Hazards in Bush's subprime bailout

PUBLISHED : Saturday, 08 December, 2007, 12:00am
UPDATED : Saturday, 08 December, 2007, 12:00am

America's subprime mortgage crisis has led to a squeeze in global credit markets as losses on securities backed by these mortgages spread and mount. Economists have warned that the crisis has the potential to push the US into recession and hit global growth. Politicians and the markets have demanded action by the US Federal Reserve and the Bush administration to get credit flowing again and limit the losses of lenders and investors in mortgage-backed securities.

President George W. Bush's plan, negotiated by the US Treasury with the finance industry, is for an interest-rate freeze to enable viable borrowers to keep up repayments and remain in their homes. As a bailout not only of reckless borrowers but irresponsible lenders who preyed on them, it raises the question of moral hazard. The concept has its roots in insurance: if someone is protected too well against an unwanted outcome, he has less incentive to avoid it. People who benefit from such protection tend to allow it to influence future decisions and are prone to repeat their errors.

The plan announced by Mr Bush and Treasury Secretary Henry Paulson arguably fits that definition. And in this case it applies to both borrower and lender.

It is ironic that the plan has been introduced by Mr Bush, who came to office espousing the principles of free markets, free trade and small government. But his administration has repeatedly caved in to political and economic pressure to help industries such as airlines and steel. And Mr Bush is not the first US president to have done so. During Bill Clinton's administration, the US Federal Reserve supported a multibillion-dollar bailout of the hedge fund Long-Term Capital Management to prevent a 'fire sale' of assets and disruption to financial markets.

Such intervention contrasts with advice given to Asian countries during the Asian financial crisis from the International Monetary Fund and the US Treasury: raise interest rates, bear the cost of massive defaults and improve transparency and regulation. For some of the countries obliged to adopt such advice, notably Indonesia, the social and political consequences were highly damaging. But as Joseph Stiglitz, former World Bank economist and Nobel laureate in economics, recently pointed out, a lack of transparency is central to the subprime crisis. And the Federal Reserve and European Central Bank's response to the current crisis is to cut interest rates, rather than raise them.

Supporters of Mr Bush's rescue package argue that the adverse consequences of not bailing out US subprime mortgage borrowers outweigh those of allowing a financial meltdown to take its course. That might be the case. But the international community is entitled to take the world's most sophisticated economy to task for failing to manage its financial industries, with all the implications this has for the health of the global economy.

Experience shows that troubled borrowers have a very high rate of default, even after generous renegotiation of their mortgages. The bailout might only delay the day of reckoning for people struggling under a heavy debt burden and may lead to bigger losses. Moreover, if investors in these mortgages are forced to accept a smaller return they can be expected to demand a higher risk premium in future, making mortgages more expensive. Moral hazard can therefore come at a heavy cost. It does nothing for the efficient operation of free markets and the image of US financial professionals proffering their services all over the world.