Sheila Bair, chairman of the Federal Deposit Insurance Corporation urged Thursday that mortgage servicers should force mortgage pools to reduce the long term interest rate at which subprime mortgages refix after the first few years, fixing the rate instead at the initial “teaser” rate. I trust no Bear’s Lair reader is remotely surprised at this development; it is typical of the soft-option-mania that has infested financial thought in the last decade. On the idea itself, to misquote Elizabeth Barrett Browning (who deserves to be misquoted) “How do I hate thee? Let me count the ways…”

Once upon a time, governments didn’t do rescues. The great Robert Banks Jenkinson, Lord Liverpool in a prime ministerial speech to the House of Lords during the 1825 speculative bubble, said: “I wish it however to be clearly understood, that those who now engage in Joint-Stock Companies, or other enterprises, enter on those speculations at their peril and risk. I think it my duty to declare, that I never will advise the introduction of any bill for their relief; on the contrary, if such a measure is proposed, I will oppose it, and I hope that Parliament will resist any measure of the kind.”

Even as late as 1929 in the United States, the established policy was not to engage in rescues. Andrew Mellon, Secretary of the Treasury under Warren Harding. Calvin Coolidge and (unluckily for him) Herbert Hoover, said in December 1929, after the Wall Street Crash: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate . . . purge the rottenness out of the system.” No sign of any bailout nonsense there!

The first sustained attempt at bailout was Herbert Hoover’s Reconstruction Finance Corporation, for which lending began in 1931and full operation began in June 1932. This was nothing short of a disaster, because it was combined with sharp tax increases and reductions of veterans’ and other benefits, thus shifting resources from the middle classes and the needy to the country’s least productive businesses. It resulted in a sharp further downturn in the US economy, which had already been battered by the 1929 stock market crash, the Smoot-Hawley tariff, the Fed’s tightening of monetary policy after the Bank of the United States crash and the internationally damaging Creditanstalt bankruptcy.

Had Hoover confined himself to modest relief payments to the truly needy, at a level the US budget could have sustained without damaging tax increases, the Depression would have turned into recovery by the beginning of 1932, as it did in Britain, and Hoover might have had a reasonable shot at re-election. However, having by his bailout put politics egregiously ahead of economic common sense and abandoned 150 years of sound fiscal management, he deserved to lose. Ironically the proposal Hoover most vigorously denounced and fought against, a $2 billion veterans’ bonus to be financed by a new issue of currency, was probably the most economically helpful thing that government could have done. It would have restored purchasing power across the broadest possible spectrum of consumers, increasing imports and assisting global trade, while simultaneously expanding the money supply. Inflation, the obvious objection to it, was not a problem at that time.

Hoover’s RFC was typical of later bailout programs; by definition the entities that get in trouble first in a downturn are those whose economic justification is most doubtful. In the unsuccessful “lifeboat” bailout of the British banking system in 1973-74 the first bank to get into difficulties, London and County, proved eventually to have a portfolio of real estate loans that was almost entirely without value. It is likely that the same will prove true of Britain’s Northern Rock, bailed out by the Bank of England a few weeks ago. Northern Rock, a fairly small and hitherto obscure building society, had expanded beyond all reason by taking wholesale funding and aggressively selling mortgage loans. As always when loans are sold rather than begged for, Northern Rock’s portfolio, owned and on-sold through securitization, appears to have been of markedly lower quality than its competitors’. Hence by rescuing it, the Bank of England subsidized the worst lending practices and the most unsound funding, at the expense of the rest of the community who have restrained themselves by comparison.

Bair’s proposed rescue suffers from the same problems, especially as it is being proposed well before the US housing market has hit bottom. Bailouts undertaken when the market is only halfway down are especially likely to reinforce failure. Under Bair’s proposed system, in which subprime mortgage loans would be renegotiated by mortgage servicers to give them a fixed rate of interest at the low initial “teaser” rate, the most feckless borrowers would be most heavily subsidized. The subsidy would effectively be paid by holders of mortgage bonds, who would see the value of their assets decimated.

The mortgage bond market would presumably be severely affected by a Bair bailout, preventing new borrowers from getting mortgages (since the savings and loans, from which they would have borrowed when the home mortgage market was properly structured, have more or less disappeared.) This would reduce house prices still further; more important it would greatly reduce liquidity in the housing market, adversely affecting the fortunes of existing homeowners, particularly those who for other reasons had to move. In turn, the subprime borrowers who had been given the lower-interest mortgages would find themselves trapped in their excessive homes, unable to move without defaulting on a mortgage that was now far larger than the value of their home. The bailout, in short, would only have made things worse.

At some point, the housing market will hit bottom, and a bailout will become possible, as supply will once again match demand. The greatest need then will be an active mortgage lending industry that is prepared to lend against the reduced value of housing without too many restrictions on the borrower. From past experience that is unlikely to be available; losses to holders of mortgage bonds and bankruptcies among mortgage banks will have decimated the industry, and those few institutions remaining in the business will have adopted a policy of extreme conservatism.

In 1980, for example, after a real estate downturn and rise in interest rates that decimated values and cash flow in the mortgage industry, I was informed that as a salaried employee of a major bank, I could qualify for a mortgage of only 1.5 times my income from that bank’s own mortgage arm. That was as foolish in the restrictive direction as the subprime mortgage bonanza was in the opposite direction, and it will be deeply damaging to the housing market and the US economy if it allowed to recur. At such a time, Fannie Mae and Freddie Mac will prove to have at least a modest worth if they are liquid and ready to make or guarantee loans, making selective bailouts that re-liquefy the market and allow lending to restart.

At present, with new home sales running at 795,000 compared with an average bottom in the last four recessions of 382,000, the market is nowhere near bad enough for a bailout to be appropriate.

The bailout impulse will doubtless recur as the wheels drop off various other parts of the ramshackle world financial edifice:

• Leveraged buyout failures will result in a surge of interest in the possibility of a state-sponsored bridge loan fund, along the lines of Fannie Mae
• Hedge fund catastrophes will result in a suggestion of a management fee surcharge on all regular mutual funds, to eliminate their unfair advantage in having lower fees than hedge funds and therefore being able to attract more money.
• Pension fund collapses will bring a bailout of the Pension Benefit Guaranty Corporation and an elimination of the limit on the amount of individual pensions that can be guaranteed by the PBGC – after all, it’s unfair that executives who have lost their stock options through a company filing for Chapter 11 bankruptcy should be compelled to have their pensions restricted to such a small fraction of their previous salaries.
• Derivatives disasters will result in a request for the forced settlement of all put option contracts at a low fixed price, on the grounds that the holders thereof were unpatriotically profiting from a market downturn.
• Emerging market debt defaults will result in a request for a massive surge of World Bank and IMF lending, to tide the emerging market defaulter over its difficulties (oh wait, that one already happened, in Argentina in 2001…)
• Asset backed commercial paper collapses will result in low interest loans from central banks to banks sponsoring ABCP conduits (no, that one has already happened, too…)

You see what I mean? Logically, there is nowhere for the bailout impulse to stop, no set of market participants so foolish or unsound that it cannot construct a rationale for aid from its customers, its business partners or the state. Normal capitalist transactions become impossible under such a system; it is a monstrous expansion of the pernicious principles that underwrite the trial bar. The world is sufficiently uncertain already, without the dangers of that uncertainty being increased by meddling governments. In a sound market, participants limit and manage their own risk, without seeking to pass it off to somebody else.

In 2020, when we have all paid the price for the forthcoming succession of ill-thought-out bailouts, these principles will be obvious and universally respected. But the process of getting to that point is likely to be unpleasant and expensive, rewarding some thoroughly undeserving people in the process.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)