Bailing Out the Sub Prime Lending Market

In his 1994 book Money of the Mind: Borrowing and Lending in America from the Civil War to the Age of Milken (New York Noonday Press) James Grant presents a tour de force of the role finance played in the building of modern America. The author traced two trends in American finance, one good and one bad. American finance has been characterized by the democratization of credit (the good trend) and the socialization of risk (the bad trend).

The Larger Trend

America was the first modern country in which credit instruments of all sorts became available to the common man, whereas in the rest of the world credit had been reserved for the wealthy few. But the democratization of credit merely reflected a larger trend in America. America was the first country in which the common man could build wealth through a system of meritocracy. Unlike the rest of the world, the accident of one’s birth did not determine an American’s place in society. What followed was an unprecedented explosion of entrepreneurship in which the common man benefited as never before. But why did this happen only in America?

Land for All

America became the first modern nation in which the common man could become economically independent, because he could easily own land. In all other societies the common man’s livelihood was a gift from the aristocracy, and the foundation of aristocratic power was ownership of land. Few commoners in Europe owned land freely, called freeholds. Most worked as rural laborers, rented land, or a few held long-term ninety-nine year leases. But even rented or leased land did not make the common man independent. All was different in America. Ownership of the immense North American continent was open to homesteaders–those who, in John Locke’s famous words, mixed their labor with the land resource to produce something of value. From this mixture of labor and land came legal land ownership. When a man owns the tools necessary for his survival he is independent and can become rich. He is no longer a vassal. (That is one of the reasons that I am so opposed to the current “Taxation for Open Space” craze. It taxes the common man to pay large sums of money to current holders of land for their promise not to improve it by building homes or businesses. I cannot conceive of a more anti-capitalistic tax. How can land be placed at the disposal of those who can place it in its most productive form, if government locks it away with our tax money for the dubious benefit of allowing the common people to gaze upon it? This is the old government-enforced aristocratic system painted in new colors. Lipstick on a pig, but a pig nevertheless.)

The widespread ownership of land created a huge customer base for credit that was impossible elsewhere. Hernando De Soto explains this process in The Mystery of Capital. De Soto uses America as an example of the proper way to perfect title in land for the benefit of the commoner. This did not happen in the Spanish colonies, where even today only a small percentage of land is legally protected by perfected title. De Soto calls such land “dead capital”, because it cannot be used for more capital intensive businesses and no one dares build a valuable abode upon it only to see corrupt authorities evict the builder as a trespasser.

The Socialization of Risk

But in Money of the Mind James Grant traced the less advantageous trend in the history of American credit—the socialization of risk. Almost from the beginning, those who were granted unprecedented access to credit clamored for government assistance when their plans went awry and they could not repay their loans. This process repeated itself over and over again. The first lenders to a new class of borrowers, often using new credit instruments, would attract the best credit risks and suffer few credit losses. As pioneers in this new area of lending, they would make extraordinary profits. Copycat financiers were quick to jump into this new market, but the best credit risks were already gone. Nevertheless, it was felt that a new age of finance had dawned (it is always a new age!) Recent experience had shown that previously uncreditworthy borrowers could be lent to profitably using new credit instruments. Grant shows that over and over the last in the new market, whether lender or borrower, were always those who suffered the worst losses when economic reality could no longer be ignored.

The Market Teaches, But Governments Waste

Bankruptcy is a hard but wonderful teacher, and eventually the market learned its lesson, at least for the newly introduced credit instrument. The credit markets settled down to the mundane task of doing good financial analysis of business plans and taking realistic collateral to protect lenders and instill a sense of responsibility in borrowers. But the lesson had to be learned again and again with the introduction of each new credit instrument.

Foolish businessmen and their customers have always lobbied for taxpayer bailouts.

The bailout of Chrysler is the most well-know case, but the bailout of Continental Illinois National Bank of Chicago in the early ‘80s set the tone for the massive bailout of the savings and loan industry later in the decade.

So we have arrived at the year 2007 and what do we read in each day’s headline? Sub prime lenders are going bust. Sub prime borrowers are shocked at the size of their new payments, as variable teaser rates expire and higher ones take effect. And what do these creditors and borrowers demand? That government bail them out with taxpayer funds. You could have read the same headlines in almost any twenty-year period since the Civil War. Our pandering politicians are there with the money. Not their own money, of course, but with our money. These poor bankers and their customers must not be allowed to go bankrupt. Oh, the Humanity! We must show them mercy and charity! Now, I am all for mercy and charity, but I prefer that everyone show such displays with his own money and not mine.

Creating a Moral Hazard

The evils that flow from these government bailouts are seldom discussed. There is the equity problem. By what right does anyone have to my money to keep himself in a home that he cannot afford? I had nothing to do with his transaction, into which he entered voluntarily if foolishly. The same for the lender and the lender’s investors. They lent the money and expected to make a profit. They miscalculated. The market will learn the lesson. But let’s not create what economists call a “moral hazard”, which means that similar transactions will happen again and again because both borrower and lender expect the government to bail them out if things don’t go as planned.

Unfortunately, that IS the lesson from previous bailouts and that is why we have the sub prime lending bailout today. In fact both PA and NJ have institutionalized the creation of moral hazard. In PA we have the Housing Finance Agency. In NJ it is the New Jersey Housing and Mortgage Finance Agency. Neither agency should exist, but spokesmen for both are demanding more “rescue” funds. What else should we expect from bureaucrats whose jobs depend upon rescuing financial disasters with public money? Expect more of the same.