Subprime mortgages, bailouts and the undead

A market failure occurs when markets operate so inefficiently that participants suffer losses.  Another bland statement: the reasons for a market failure are obvious in hindsight.  The 'Subprime Mortgage Crisis' is a spectacular market failure.  It is similar in its dimensions and profile to the Savings and Loan Crisis which occurred between 1986 and 1995 and unwound 1000 banks with assets of over $500 billion.
        Make no mistake - it is a crisis. Since 1998, more than 7 million borrowers bought homes with sub-prime loans. One million of those homeowners have already defaulted on their loans The crisis is likely to get worse. Financial analysts predict that at least a quarter of these people - some 2 million families - will default and face the financial pain and psychological grief of losing their homes over the next few years.
        A bailout occurs when the political costs of allowing a market correction are too dangerous.  The S & Ls were bailed out and the taxpayer bill by 1999 was around $157 billion in 2007 dollars.  The Subprime mess has not run its course. In May 2008 the most promising congressional proposal - when the smoke and mirrors get put away - guarantees up to $300 billion in loans to keep people from losing their homes.
        The word "bailout" is politically charged and legislators are pedaling backwards as hard as they can to avoid saying it.  So the bailout is not a bailout and it is being constructed with plausible deniability. There will be painful participation by borrowers, lenders, and government surrogates. Taxpayer money will not be used because of fees collected by Fannie Mae and Freddie Mac from the loan originators; Fannie Mae and Freddie Mac are federally chartered but not federal.  Mortgage loans may be written down.  Borrowers may have to split any capital gains with the government if they sell their homes.  The Federal Housing Administration, although guaranteeing $300 billion in loans, will not have to use taxpayer money because of all the fees being collected.   
        The final default rate among up to 500,000 sub-prime borrowers is anybody's guess.  If half the dollar amount of all the loans go into default, that would make the Subprime bill about as big as the S & L tab.  Unsaid is who pays if all the fees collected don't cover the defaults.
        Blame, or avoiding blame, is important when something like this hits the fan.  The easiest targets are the victims.  But of course, they are not victims.  They are shiftless no-account losers who had no business applying for a loan when they knew damn well they couldn't pay it back when their ARMs readjusted.  Serves them right for also buying slogans like "the Ownership Society" or assurances like "home prices only go up". 
        That is the general sway of public opinion - these delinquents are adults.  Even if they can't make heads nor tales of the fine print of a contract, the basic features are well within the understanding of anyone eligible for even a subprime loan.  It was wishful thinking and therefore irresponsible to take out the loan.  There is little belief in innocent victimization from "predatory lending". 
        That attitude is pretty durable as you travel up the food chain.  Brokers will talk about their slim margins and the ingratitude of the deadbeats now in danger of losing their homes.  Investors will be amazed and indignant at any suggestion that they should be asked for forbearance.  How do you keep the entrepreneurial spirit alive if you ask investors not to take the financial recourse to which they are entitled?
        The geniuses who jury-rigged the bundled, traunched and differentially rated securities out of a vast sea of questionable debt are genuinely surprised that the ropes of sand dissolved.  But it's all in a days work and they are ready to move on.
        But the Fed and the politicians are paying attention.  The Fed is throwing money into the sputtering engine of the economy as fast as it can bail.  Ben Bernanke, Chairman, is a very keen student of the Depression and knows what not to do.  He is not raising interest rates such as the federal funds rate or the discount rate.  He is finding every excuse to pump money into a money supply ready to go limp.  He is also coming to the rescue of some very big fish like Bear Stearns but the trickle-down of the great stream of money is not confined to the investment banks.
        Franklin Roosevelt was inaugurated - the first of four times - on March 4, 1933.  He set a record for requesting and signing a flood of new legislation in the next 100 days that still stands.  He was able to do this in large part because the congress was running scared.  If they gave the president what he wanted, they could blame him for the failure.
        The dynamic today is certainly not the same.  There is essentially no credible leadership from the executive.  But the Congress is still very vulnerable to being labeled do-nothing in the face of catastrophe.  In spite of the articulate thunderhead of verbiage from the letter writers and bloggers, the vote-getters recognize an incipient populist backlash when they see one.  And both the Fed and the Congress do not want the very real prospect of economic collapse to come home on their watch - no matter the scorn of the pundits and free traders.