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Wednesday, November 12, 2008

The New Mortgage Bailout: Government Imposed Moral Hazard

The other day a colleague showed me a modified loan they are using as a selling point for loan modifcations. This particular borrower was fitted with a brand new loan from a large well known bank that would give the borrower a rate of 4% for the next five years. After that, the loan would go up to 6% for two more years and then 6.75% for the duration. This is the possibility for a borrower in a tough spot. They aren't merely going to get a loan they can afford. Instead, this is a loan would make a perfect borrower envious.

We should all keep this in mind as we read this story.

Fannie Mae and Freddie Mac, which are under government control, said they would thousands of homeowners who are 90 days or more behind on their mortgage

The Bush administration said it would use the mortgage giants to extend aid to struggling homeowners, a move met with criticism from a top federal regulator, lawmakers and others, who charged it doesn't do enough to stem home foreclosures.

The response intensifies an already fraught debate over the government's approach to the mortgage crisis, which has cast a long shadow over the U.S. economy, from restaurants to auto makers to retail stores.

The Federal Deposit Insurance Corp. and some lawmakers support using part of the government's $700 billion in bailout funds to spur much broader loan modifications. So far, the Treasury and White House have resisted and questioned whether that idea would be effective given the costs to taxpayers.

What the Federal government has just done is allowed for a mass number to get the deal I just described in the first paragraph. Loan modifications are done based on ability to pay not based on qualifications. As such, borrowers in especially bad situations are the ones most likely to get the lowest rate.

Because the Federal government is determined to stop the spread of a mass number of foreclosures, they are also now in a position to give millions of unqualified borrowers that would make A+ borrowers jealous. Because this plan is only open to those 90 days and more behind, it will only be open to those that are far behind on their mortgage. This plan is not merely the definition of moral hazard but frankly it redefines it.

Borrowers are in over their head. They are so far behind that they haven't made a payment in the last 90 days and more. Now, the Federal Government, through their new subsidiaries Fannie Mae/Freddie Mac, will swoop in and give them newly minted loans. The new loan terms could be as low as 4%, and possibly, it may even be lower. In other words, you take on more than you can afford, and you are rewarded with a loan that isn't merely better than that a perfect borrower could get. Sometimes, that loan would make such a borrower jealous.

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