Truth or Dare

Truth or dare. You remember this game. We all played it when we were young. When your turn comes round, someone in the group gives you a devilish choice … tell the truth about your deepest darkest secret or face a trial by fire. If you refused to fess up by divulging your confidence, then you were forced to do something unspeakable … you know … like running around the room in your boxers, while belting out the lyrics to “I Feel Pretty” from “Westside Story.”

Whether you knew it then, this adolescent challenge was preparation for the morality play that we would face countless times as adults.

Okay … Truth or Dare.

When you heard that the Fed rescued Bear Stearns by underwriting the failed firm to the tune of $30 billion dollars, did you do a jig? Did you secretly stand up and cheer because those poor bastards --- Bear Stearns execs --- could keep their billion dollar bonuses? If you didn't applaud the Fed's action, were you willing to let the Wall Street giant collapse under the weight of its own ill-conceived risk? Did we dare?

Now Congress and the President are proposing to bail-out hundreds and thousands of borrowers across the nation facing foreclosure. This is where the rubber meets the proverbial road.

Truth or Dare.

Is there a greater risk to the economy if we let these borrowers fail or does the real peril come from taking the seemingly most compassionate course?

Risk transfer is the gist of modern economies. The vitality of the any economy is predicated on the notion that some players will prosper while others will fail. A “moral hazard” arises when an individual or institution does not bear the full consequences of its actions, and as a result, has a tendency to act less carefully than it otherwise would, leaving a another unanticipated party to bear to some or all of the loss. In other words, if investors are led to believe that there is a “safety net” ready to catch their fall, then it more likely that their perception of risk will be distorted. As a consequence, they more freely undertake levels of risk that they otherwise would eschew.

Consider this … if I build my house in a heavily forested area, knowing the risk of wild fires, should I expect the government to rebuild my ravaged home if I didn’t carry adequate insurance to cover my full loss? The same may be asked of borrowers and speculators who took advantage of historically low interest rates to purchase property at record high prices. Just like the homeowners on the mountaintop, they had to know that eventually they would face a wall of flames.

While a government rescue may be politically expedient in this an election year --- or the compassionate course --- the fundamental threat to our economy could be magnified if our public institutions step in to save the day.

The reallocation and transfer of risk have become booming industries. Governments, capital markets, banks, and insurance companies have all entered the fray with ever-evolving financial instruments. Pundits praise the creativity of these often exotic risk spreading devices. In the greater marketplace, these risk dispersion mechanisms allow entrepreneurs to assume more of it, banks to get rid of it, and traders to hedge against it.

But this is precisely the peril of these new developments. They mass manufacture moral hazard. They remove the only immutable incentive to succeed --- market discipline and business failure. They undermine the very rudiments of capitalism: prices as signals, risk and reward, opportunity costs. Risk reallocation or transfer of the type being proposed for this class of investors produces an artificial universe in which synthetic contracts replace real ones and where moral hazards replace genuine business risks.

It’s no surprise new investors and home buyers were lured into the real estate market. The sirens’ song of cheap money is a temptation difficult to resist. New borrowers were blinded by teaser rates, the prospect of purchases without down payments and the seeming ability to set their own initial monthly obligations. Market propagandists spun a world in which property values would rise without end. In short, the makings of a “perfect storm.”

The first concept that most economics and business students learn is that for every benefit, there also is a cost --- for every reward, there must be risk. Much as we’d like to believe otherwise, there is no free lunch! Unfortunately, as tragic as this may be, if our economy is to thrive in the natural course, these borrowers may have to be casualties of “Economics – 101.”



To learn more about my market recommendations, visit my website at:www.globewestfinancial.com.