Freddie Mac and Fannie Mae are private companies that operate under a Congressional charter. [3] They were created to make a market for low-income higher risk borrowers.  [4] Essentially, the two companies operate by purchasing higher risk mortgages from other lenders. [5] The loans are underwritten by the US government so there is very little risk involved. [6] The recent Congressional proposals focus on some form of a subsidy to Freddie Mac and Fannie Mae. [7] The government will give the two companies money to buy out defaulted mortgages, refinance the terms, and allow troubled home owners to stay in their homes. [8] Home owners, private investors, and Freddie Mac and Fannie Mae are all on board since they all reap immediate financial benefits from the subsidy. The problem, however, is that this type of Congressional meddling will only create a moral hazard and harm the housing market in the long run.

Moral hazard refers to the lack of incentive to guard against a risk when there is protection from it. [9]   It may also refer to an incentive to engage behavior that is of higher risk if not for the incentive. [10] The term is commonly used in the insurance industry. [11]  For example, auto insurance coverage may create the moral hazard of high-risk driving since the driver does not bear the financial risk of crashing the vehicle.  The Congressional proposals would create the moral hazard of lending to high risk and otherwise unqualified borrowers.  The financial subsidy would reward lenders for handing out bad loans.  Since the subsidy would likely target troubled, higher risk borrowers, under certain circumstances it would be financially advantageous to lend money to higher risk borrowers over lower risk borrowers.

Investors are only willing to take on risk if they are compensated for that risk in the form of higher returns.  Investment banks, pension funds, and bondholders that invested in the subprime mortgage market were compensated for that risk.  These types of investments were paying higher returns through the housing boom and the investors were fully aware that at some point, the risk may materialize.  If Congress goes through with its plan, future investors will not accurately account for the true risk of investing in subprime loans because they will expect that, in the event of another crisis, they will only bear some of that true risk.

So what can Congress do fix the subprime mess?  There is no quick solution.  Politicians will have to face the fact that some homeowners will default on their mortgages and some lenders will not survive the downturn.  In the long run, Congress should focus on identifying inefficiencies in the mortgage market.  Gains in efficiency will free up money that lenders can loan to more potential homeowners.  This, in turn, will drive down mortgage rates and make home ownership possible for more people.

Sources:

[1]  Markets and Data Weekly Indicators: Overview, ECONOMIST, Sept. 27 2007, available at http://www.economist.com/markets/indicators/displaystory.cfm?story_id=9867611 (last visited Oct. 6, 2007).

[2]  Nicole Gelinas, Congress to Rescue?, CITY JOURNAL, Mar.16, 2007, available at http://www.city-journal.org/html/eon2007-03-16ng.html (last visited Oct. 6, 2007).

[3] Id.

[4] Id.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] BLACK’S LAW DICTIONARY 723 (Deluxe 17th ed. 1999).

[10] Id.

[11] Id.