Bad Decisions Were Ours

in In Defense of Capitalism by

housing-bubble1Don’t compound them with bailout for mortgage ‘victims’

The housing bubble that was fueled by multidecade low interest rates priced many people out of their dream homes. But instead of settling for less or renting, people went after their American dream with a vengeance – taking out adjustable-rate, interest-only or, even worse, negative-amortization loans. Good things end, and great things end with a big bang; the burst of the nationwide housing bubble has left many with shattered homeownership dreams and financial despair.

And now the blame game starts. It must be the builder who charged too much for the house, or the “blood-sucking” mortgage broker who facilitated a loan, or the bank for extending credit we should never have had. Now, there’s a new extreme – the investors who purchased our mortgage with thousands of others from financial institutions.

The blame falls on us and none of the above. Though we want to blame the financial institutions for coming up with these products, as long as loan terms were fully disclosed, it is our responsibility to make the right financial decisions, not theirs. Any product can be dangerous if not used responsibly. Even a hair dryer, if used while taking a shower, could lead to untimely death. The financial products (i.e. mortgages, home-equity loans, credit cards) are electrified by compounding, and if not used appropriately, could lead to financial distress.

Though some would like to – and many will – pleading ignorance is disingenuous. With the exception of outright fraud, buyers knew they were biting off more than they could chew. They knew interest rates would reset and mortgage payments could increase, or at least it was their job to find out before they committed to the biggest purchase of their life. But that was in the future, and they lived in the now. The future is today, and there is a price to pay. We need to stop blaming everybody but ourselves and own up to our mistakes.

We hear sad, heartbreaking stories of eviction, broken families and pecuniary anguish resulting from people losing their homes all over the country. Of course, we want to help these folks in trouble. Our first instinct is to look at our almighty government for help. Though government sounds like an ambiguous third party, it is not – it is you and me. Should you and I carry the burden of those who made irresponsible or simply bad decisions? Money is a finite commodity, thus for the government to bail out the victims of this housing debacle, it either will have to raise taxes, cut spending or both. Yes, you and I will be paying higher taxes and/or money will be diverted from cancer research or other social programs because your neighbor elected to live in a larger house, better neighborhood or to have a greener lawn.

But that is just the beginning. The largest cost of a government bailout is the one that is not apparent at first – the moral hazard. In a free economy, incentives are set up in a way so that decisions made in our best interest also benefit society,or the system as a whole. Introduce moral hazard into the equation and individual decisions can benefit participants but hurt the system. The unintended consequence of a government bailout could be catastrophic.

The politician will tell you that only victims will be assisted. They’ll make sure not to call it a bailout. It is close to impossible to identify who the true victims are. Were they the ones with bad credit who took out subprime or Alt-A loans? Or the ones who are facing ARM resets? Maybe the ones whose house value declined because their neighbor foreclosed on his?

Politicians will come up with creative definitions of victim, but the result will be the same – the number of people who fall under the victim umbrella will mushroom exponentially, far exceeding original expectations – the unintended consequences. Homeowners who had all intentions of paying on their mortgages will ask for the government’s (now available) assistance. The ones who could not afford their house in the first place will get a couple years of free rent out of the system, ultimately defaulting on their mortgage a couple of years down the road.

In addition, the bailout will introduce an asymmetric payoff for current and future homeowners: Owning a house will become a risk-free endeavor. If your house price goes up, great. If it goes down, you claim to be a victim and society compensates you for the risk you’ve taken. A risk-free, utopian paradise, isn’t it? This will set the stage for an even greater next housing crisis.

The next couple of years will uncover more fraud committed by some unscrupulous mortgage brokers and banks. Some small elements of fraud are uncovered at the end of each boom: the junk bond boom of the late 1980s, S&L crisis of the early 1990s, the Internet bubble of the late ’90s, and it will happen again. Our economic and legal systems are equipped to deal with these people – they’ll go to prison. And politicians, like vultures, will feed on our misplaced anger. Like superheroes, they stand up to protect the little people (us) against the evil empire by creating “housing reforms.” But you cannot legislate common sense. With freedom comes responsibility. Do we really want to give up freedom and have government bureaucrats decide who should or should not get a loan? Instead, lawmakers should focus on making the lending process simpler and more transparent, where the terms of the loan are clearly spelled out on one page.

Doing nothing is the hardest thing to do when you see people in distress. We are a compassionate people, and we want to help. But there are times when we have to restrain ourselves and do as little as possible because by helping some you’ll hurt many others. This is one of those times. The current crisis will pass, as have many before. Let’s not escalate the magnitude of the next one by irresponsible actions.

Vitaliy Katsenelson, CFA, is a portfolio manager at Investment Management Associates in Denver. His book ,Active Value Investing: Making Money in Range-Bound Market, will be published by John Wiley & Sons at the end of September.

This article originally was published in the Rocky Mountain News


  1. US Government to the rescue has been in force for years. Just think of all the government pork and social programs that have run amuck and now are a huge unfunded liability. Thing of rebuilding New Orleans, a colossal waste of money given that the city is below sea level and nothing we can do will save it from the Global Warming now in progress. Think of the airline bail outs. the savings and loans, the American farmer … I could go on.
    I am for a bail out of some kind because the unintended consequences could impact the very economy that has provided the credit for all of the above. A recession will be far more hurtful to everyone then sending Uncle Sam in to save the day.
    Perhaps we need better care in spending money in the first place. Given our system it will take a catastrophe of some kind to change that. I, for one, don’t think it will happen for some time so we will continue to muddle thorough.

  2. Terrific, concise, and effective article. I wish your viewpoint was accepted by those who should know better.

    Keet up the good work.

    With appreciation,
    Charley Neer

  3. Thank you for writing an article that expresses views similar to my own. My family and I moved to California from Europe in 2003 and decided to wait out the mania in the market in Southern California and rent (almost a dirty word here). We did so while watching everyone spend recklessly. No prudence whatsoever. To make matters worse, the only conversation around the dinner table was about the current value of one’s house (living London was even worse). Boring to say the least.
    Hopefully the market will return to levels that are affordable on standard lending terms. Work hard, save your money and eventually your get your slice of the dream.
    Thanks again.

  4. That’s a bit oversimplified. There are certainly many homebuyers and speculators who did the math, knew full well the risks, and were able to understand the contracts. Yet they were surely sent many signals; however — from the President to Greenspan to the financial press — that they were not in fact taking a risk. The President said so in exactly that many words. Nevertheless, they have a college education and they signed the contract.

    It took every bit of will in my body to not sign onto a mortgage I cannot afford, while all my friends and neighbors did. I am not yet convinced that I didn’t make a mistake, as the house prices have left me behind and I may never catch up. Currently, with a 50 bp easing, I am still the one looking like a fool.

    There is another segment though, the desperate and the marginalized. These people were not so well informed or able to navigate our complex personal economy and its promoters. To them, the pressures were felt more deeply, the dangling of easy credit like setting a drink in front of an alcoholic. Sure, they too signed a contract. Laws may not have been broken, perhaps, but the tactics and opaqueness and pressure may not be something many mortgage brokers will brag about to their mothers. Let’s face it, there is a segment of our society that is exploited for their ignorance and lack of spophistication and desperateness. We can hide behind the signing of contracts, but I would not bank on that getting me into heaven.

  5. Vitaliy;

    I understand the thought behind not bailing all people out and how logical the thought process is for that point. People knew what they were getting into. People were gaming the system. If the game doesn’t work, you pay the price… I agree completely.

    HOWEVER, if that is the case, then it needs to be a standard held to all cases, all situation, all social-economic levels, public, private, corporate. And, quite simply, it is not. We forgive/forget the executives in the option dating scandals. We allow businesses, but not John Q Public to walk away from financial woe via bankruptcy. We bail out those involved in the S&L crisis. Oh, we bailed out the airlines multiple times.

    Frankly we actively damn John Q Public for being dumb, irresponsible, gaming. Yet the same high risk activities when taken by executives, entrepreneurs, money managers are forgiven, viewed upon as strengths (having vision, maximizing alpha, maximizing a loophole) This is what I find amazing. It really should be flip flopped because the latter is much more educated on what they’re doing than the average home buyer.

    I simply do not think that we can take your position on the home buyers without seriously examining our values elsewhere.

  6. Great Article. Right on the money. You could have also mentioned how much money many of the homeowners made by flipping houses or equity stripping thru continuous refi’s. They rolled the dice and won. The people that are losing are the people that got into the game too late or kept pushing their luck.
    All investments have risks and the investor should deal with the loss and not be bailed out with my tax dollars.

    When people went into 2 yr ARMS they were betting that home prices would continue to appreciate, they were wrong and they lost.

    The government is now all about setting up tighter lending standards. Bad idea. The cow has already left the barn and the tighter lending standards that have been put in place by the lenders are resulting in foreclosures going up because people can’t refi out of their short term ARMS.
    Wall Street, the lenders and homeowners all made millions over the last 5 years and now we need to let the cycle takes it course and let the chips fall where they may.
    So what if somebody gets foreclosed on, it is not like they can’t go rent a home to live in. They are not going to be living on the street.

  7. I share #6’s thought exactly. I would only add that we just bailed out the New York Stock Exchange last week with a 1/2 point interest cut. When is the corporate class going to pay for their mistakes?

  8. Interesting article and many valid points by others that want to take the concept of moral hazard into a much wider realm.

    In all this sub-prime cesspool, there is one category I would like to see in jail. Those salesmen who approached poor people on a $2000 a month pension and sold them a mortgage with a 1% interest rate (for 1 day) and then wrote up the income of these poor people as $8 900 a month. These salemen and women KNEW were selling these poor people a mortgage that they would never be able to repay. Their bosses knew it and encouraged it.

    Then while these poor clients began defaulting on their mortgages the nominal income record on the mortgage forms ensured that the false security in these securities remained hidden. Their bosses wanted to get rid of these failing mortgages so they were quickly re-packaged as securities sold the world over qhile in fact they were worthless. The world is now paying in loss and hardship for the actions of these ‘salesmen’ and ‘saleswomen’.

    Oh, pundits of the financial and legal world, please tell me: Does this crisis not have its origin in fraud, and why are the fraudsters not in jail?

    Unless someone can prove to me that it is not fraud, and especially if the government is you and I as several writers have claimed and yet nothing has been to jail these fraudsters, then I have nothing against the government helping the poor people who were mis-sold those mortgages. These were the people who were most disadvantaged, these were the people who were screwed first and worst. Most of them have been turned from poor but surviving honest citizens into homeless people, chased by debt and in risk of jail for the rest of their lives.

    Then how is it that all the great educated banking and finance staff in the world bought these ‘securities’ without checking? Is time and a fast buck and another car so important to this category that they didn’t do the basic checks? If Goldman Sachs did their homework and studiously avoided these securities, why didn’t the others? Was it because the others were involved in the fraudlent mis-selling in the first place?

  9. In the article “bad decisions were ours” the comment is made: “The largest cost of a government bailout is the one that is not apparent at first – the moral hazard. In a free economy, incentives are set up in a way so that decisions made in our best interest also benefit society,or the system as a whole. Introduce moral hazard into the equation and individual decisions can benefit participants but hurt the system. The unintended consequence of a government bailout could be catastrophic.” I hear this often but do not recognize it often. Are the some examples out there that you can refer to? Subsidies to Farmers are bad but are they a moral issue? I seem to be missing something.

  10. Sure. A great example would the the social “benefits” in Western Europe. If you lose a job, government offers very comfy unemployement benefits which creates great dis-incentives for you to look for a job. This leads to higher unemployment, higher taxes, slower growing economies etc….  This time around government intervention will cause a change in our behavior.  Homeowners will sick a lot more risk in the future as they’ll believ the government will bail them out in the future.



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