The Obama administration is considering the “moral hazard” of trying to help homeowners struggling with plummeting home values and the negative equity produced by the mortgage exceeding the current property value. According to the Wall Street Journal, some borrowers may game the system by defaulting on payments in an attempt to receive a loan modification workout with their lender. Still, the banking industry and Wall Street fiercely resist loan modification despite having teamed up to profit from loans extended to those unable to pay.

first tuesday take: The greatest recent creation of moral hazard was the massive mortgage fraud perpetrated by Wall Street investment bankers who were able to take the real estate mortgage market “public” as never before. To allow moral risk (or moral hazard) to come about in financing, you need only the normal, routine conduct of the Federal Reserve pouring excessive amounts of money into the markets when the need looks legitimate. It did so during the financing of the government policy to push homeownership to 70% (from 64% in 2000). Fed lending in itself is not the hazard and does not create a risk, even of inflation—it’s just money supply.

But it was the failure of the Federal Reserve to place the proper cost (interest rate/reserves) on bank borrowing of the Fed funds for investment in mortgage-backed securities which funded the Wall Street bankers and the mortgage loan bankers. Rates charged by the Fed were dangerously low; way below the rate of inflation, and the spread up to mortgage rates was, to be kind, unreasonably generous to Wall Street investors. Couple the initial failure of the extremely low Fed rates and the length of time these rates remained available, with the other failure of government oversight to regulate the risks the mortgage bankers originating the loans could build into the terms of these loans the Wall Street mortgage bundlers were allowed to pass on to the millions of small village investors and you have created a most immoral cocktail. The excess lending to unprepared borrowers secured by over-valued real estate on payment terms of laughable irrationality was the risk which resulted from low Fed rates and unregulated risks permitted for the entire secondary mortgage market.

There is a saying among old-timers in real estate: “When Wall Street gets into real estate, they screw it up every time.” But with the help of the Federal Reserve and government deregulation of lending, Wall Street ratcheted up leveraging like never before: the double-edged sword.

Re: “Finessing ‘Moral Hazard’ Is Tough in Housing Plan” from the Wall Street Journal