Quick Take: No Bailouts for Anyone

When HSBC Holdings (NYSE:HBC) announced it was upping its reserve for bad loans, that turned out to be just the beginning. Since then we've seen New Century go belly-up and the shares of Accredited Home Lenders (NYSE:LEND), Impac Mortgage Holdings (NYSE:IMH), Countrywide Financial (NYSE:CFC), and everything else with a hint of subprime punished to some degree. That's not even mentioning all the non-publicly traded mortgage lenders to disappear lately.

Earlier this month, the government finally announced it would begin to clamp down on the industry and make sure borrowers fully understand what they are signing up for. Now comes word from Senator Dodd that on top of reforming the industry's sordid practices and questioning regulators as to why it took them so long to act, it might also be time to consider offering a bailout to borrowers.

Dodd is right that regulators need to explain why they weren't cracking down on lending practices in the subprime industry before now and to clamp down on predatory lending practices. But bailouts are out of the question and, really, just plain dumb. Bailouts won't really help fix anything. Our system works because people take risks, and they live with the consequences or reap the rewards. When you start bailing out anyone for taking a risk, you only encourage the behavior you want to curtail.

Some borrowers are going to suffer. That's the way the system works. Some lenders are going to suffer, too, and deservedly so. Write bad loans and you don't get your money back. The only people that deserve help are victims of outright fraud -- whether they be borrowers or lenders -- and that should be resolved in the market and the courts, not with any form of financial assistance from the government to borrowers.

Its likely that Senator Dodd made the suggestion to gain favor with voters. And some of them, no doubt, would gladly take a bailout. But if Dodd really wants to get to the root of the problem, he'll turn to his counterparts on the education committee and ask why people get through high school without being able to understand how a loan works from start to finish, and focus on how things got so out of hand in the industry in the first place. If there are real crimes here, those are the ones to go after.

As an aside, I don't think we're by any means done with lenders seeing pain. There are other companies out there with varying degrees of exposure to the subprime market, and there are option ARMs that have yet to reset. I'm most interested to see what happens when investors and the general public realize lenders such as BankUnited Financial (NASDAQ:BKUNA) and Downey Financial (NYSE:DSL) are sitting on billions in option ARMs, have low reserves, and have little or no earnings once you adjust for interest income not received on negative amortization loans.

This interest income is recognized properly by the companies according to GAAP, but it is not actually cash coming in the door. The dirty secret is in the cash flow statement and the footnotes. To believe the earnings accurately represent economic returns is to believe all the cash is going to eventually come in. The truth lies somewhere in the middle, and I think we'll ultimately see large adjustments and charges to reconcile accounting returns and economic returns.

Comments? Bring them here.

At the time of publication, Nathan Parmelee had no financial position in any of the companies mentioned. Despite the rant, he thinks a number of good banks are being punished with the bad. He's also ranked 40th out of 24,312 investors in Motley Fool CAPS. The Motley Fool has an ironclad disclosure policy.