Bernanke Has a Point. Maybe.

Ben Bernanke bashing has become a fashionable pastime. When the chairman of the Federal Reserve has a nickname like "helicopter," you know passions are running high.

The Fed chief's comments on Tuesday suggesting that mortgage principal reductions "may be a relatively more effective means of avoiding delinquency and foreclosures" are new fodder for those who think the Fed is making the problem worse.

I wade into this fray with no small amount of trepidation. After all, I'm not an economist (which is fortunate for all parties concerned), just a run-of-the-mill Foolish investor. But looking carefully at what Bernanke said, there appears to be a grain of truth amid the mountain of moral hazard in his suggestions.

A handout, plain and simple
When I read the headlines, my first reaction was that this simply doesn't make sense. Why should a homebuyer get a reduction in the principal amount? That's a plain and simple handout to someone who bought a house they couldn't afford.

The moral hazard appears almost unfathomable. If people don't have to be responsible for their actions, then contracts as we know them have no meaning. By the way, my daughter just smashed her car -- and I chose a high deductible on my auto insurance to reduce the payment, and I'm a little short this month. Hey, insurance agent, it's your responsibility to help me out.

Homeowners may have been unwise in choosing an adjustable-rate mortgage with a quick reset, but they sure as heck knew and agreed to the price they paid for the house. Apply that logic to the corporate world and you'll have Home Depot (NYSE: HD  ) calling back takers for its disastrous Dutch auction last fall and suggesting they donate a portion of the proceeds back to the company because the stock price then fell.

Other arguments against reducing the principal seem compelling:

  • The banking system can't afford these write-offs.
  • If housing prices continue to fall, banks would just have to write them down again.
  • If housing prices rise, homeowners who got the handout would stand to gain.
  • Who would qualify for this largesse, and could it be applied across the wide spectrum of lenders and loan servicers in a way that is fair?

This argues for the tried-and-true methods of reducing the rate or arranging a "workout" where the borrowers get more time to catch up on delinquent payments. It's fair, preserves the sanctity of the contract, and has worked in the past.

A grain of truth
But the Fed chairman makes a convincing case that the old approach won't work this time around, or at least not as quickly and completely as the economy needs. Consider:

  • More than one-fifth of subprime ARMs were seriously delinquent at the end of 2007, and foreclosure rates are running 50% ahead of the previous two years, year over year.
  • More than 40% of subprime mortgage loans in 2006 had loan-to-value ratios of more than 90%: Many of the borrowers have little or no equity in the property.
  • In the past, the combination of rising home values and a higher ratio of equity allowed stressed mortgage holders to sell or refinance their way out of the problem. But low equity, falling home prices, and a nonexistent subprime lending market means this solution won't work today. (I'm liberally paraphrasing several of the chairman's remarks here).
  • Delinquencies and foreclosures will continue to rise because more than 40% of subprime ARMs will reset to higher rates this year.

In short, we're experiencing a "cluster" that's getting worse, not better. Recent moves by lenders who are postponing some payments are helping, but not quickly enough. And they're not an adequate solution for the continuing avalanche of foreclosures.

A radical idea
I won't even consider touching on who is at fault here -- there's enough blame to spread liberally among borrowers, loan packagers, ratings agencies, and anyone else you care to name. I don't place the origins of this problem at Ben Bernanke's doorstep, but I am encouraged that he's suggesting some radical ideas to climb out of the hole.

Lenders could take some principal write-offs. Citigroup (NYSE: C  ) and UBS (NYSE: UBS  ) have collectively taken more than $30 billion in hits. A way could be found to equitably share the upside when housing prices recover. I have no idea how to equitably decide who qualifies for reducing their principal, but free markets could find a way to sort this out if Congress would keep its nose out of it. The point is that when the Fed chairman says we need to find new solutions, we should either listen or get a new chairman.

A Foolish conclusion
I expect to take some heat for this point of view. Fine. I'll just shake it off and go back to looking for ways to profit in a shaky market. I'm liking the looks of companies like Kraft (NYSE: KFT  ) (and so is Warren Buffett; he just accumulated a big stake); Wal-Mart (NYSE: WMT  ) , which looks to be back in its element; Kohl's (NYSE: KSS  ) , which appears to have solved its inventory problems; and Costco (Nasdaq: COST  ) , where shoppers are bulking up regardless of what the Federal Reserve does. So, happy stock hunting, and give Ben a break. He's got a lot on his plate right now.

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