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The Cost of a Government Bailout


The 2001 rate cuts caused the bubble that is now a crisis. Here we go again...

Editor's Note: This article originally appeared in Business Week on October 1, 2007 and is being republished here for the benefit of the Minyanville community.

I've seen this movie before, and it doesn't end pretty. That's what I thought on Sept. 18 when Federal Reserve Chairman Ben Bernanke took the road so often traveled by his predecessor, Alan Greenspan, and threw the financial markets a sop in the form of a big cut in interest rates. It was clearly what the markets wanted, as the immediate 336-point jump in the stock market confirmed. But popular decisions are not always the right decisions. (Just consider Greenspan's popular 2001 interest rate cuts, which actually caused the current housing bubble.)

Indeed, at the core of today's credit mess-whether in housing or the now battered markets for commercial paper-lies a glut of global liquidity. That has dramatically altered our perception of risk and fueled an unwillingness to accept traditional credit limits. If a homeowner couldn't qualify for a conventional mortgage, brokers were more than happy to offer an exotic loan the borrower could never realistically pay off. If a loan was too risky to be sold as investment-grade, investment banks could always concoct elaborate bundles of good and toxic credits that (supposedly) eliminated the risk.

Nowhere was this disregard of financial reality more apparent-or damaging-than in housing. The housing bubble was fueled by many years of low interest rates, which eventually priced many people out of their dream homes. But instead of settling for less or renting, people pursued their American dream (the house with a white picket fence, 2.7 kids, and 1.2 dogs) with a vengeance, taking out adjustable-rate, interest-only-or even worse, negative-amortization loans.

It was great while it lasted. But all good things end, and great things end with a bang. In this case, that bang was the bursting of the housing bubble. That's also when the blame game began. Some blamed builders who charged too much for a house, the mortgage broker who facilitated a loan, the bank for extending credit the buyer should never have had, or even the hedge fund that bought the loan bundled with thousands of others.

Yet, except in cases of outright fraud, most buyers knew interest rates would reset and mortgage payments would go up. Or at least it was their job to find that out before they committed to the biggest purchase of their lives. But that was in the future, and they lived in the now. No longer.

With all the heartbreaking stories of eviction, broken families, and pecuniary anguish resulting from people losing their homes, our first instinct is to look to government for help. There are proposals in Washington to bail out specific lenders or even to penalize Wall Street buyers of asset-backed securities. But remember, government isn't some ambiguous third party-it's you and me. Should we carry the burden of those who made irresponsible or simply bad decisions? For government to bail out the "victims" of this housing debacle, it will have to raise taxes, cut spending, or both. Yes, you and I will pay higher taxes or money will be diverted from needed social programs because your neighbor elected to live in a larger house, better neighborhood, or to have a greener lawn.

But the largest cost of a government bailout is one that is not readily apparent-the so-called moral hazard, wherein society shields investors from the fallout from their actions. The unintended consequence of a government bailout is that it sets the stage for an even greater housing crisis next time since it suggests to purchasers that owning a house is a risk-free endeavor. If your home's price goes up, great. If it goes down, you claim to be a victim, and society compensates you for the risk you've taken. With screwy incentives like that, the cost of the next bailout will make today's housing crisis look like a cakewalk.

That's why Bernanke should forgo further cuts, let market forces work, and allow the economy to go through a painful but needed withdrawal from its addiction to low rates. If the Fed continues the easing it started this week, it will reinflate the housing bubble, further stretch the already overleveraged consumer, and risk enabling bubbles in other asset classes.

Doing nothing has always been hard for Americans. But there are times when we have to restrain ourselves, since by helping some we risk hurting many, many others. This is one of those times. The current crisis will pass, like many before it. Let's not escalate the magnitude of the next one through well-meaning-but irresponsible-actions today.

Vitaliy's recently published book, Active Value Investing: Making Money in Range-Bound Markets is now available for purchase. AVI has two parts: in part one, Vitaliy makes the argument that there is a very high probability, that over next dozen years or so the U.S. stock market will be range-bound, going nowhere, similar to what we observed since 2000. In the second part, he provides a very practical, actionable investment guide to investing in range-bound markets.

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