Tuesday, June 19, 2007

Gee, Ya Think So?

by Ken Houghton

Via CR, who got it from Nouriel Roubini, this from the FT:
[Ben Bernanke] told a conference hosted by the Atlanta Fed that, in addition to making homeowners richer or poorer, changes in house prices might influence the cost and availability of credit to consumers.

This is because people with equity in their homes have more at stake in avoiding default. That, in turn, reduces the premium charged by lenders owing to their imperfect knowledge of their borrowers’ financial circumstances.

If this theory is correct, Mr Bernanke said, “changes in home values may affect household borrowing and spending by somewhat more than suggested by the conventional wealth effect”.

There is, however, a sentence to which I wish to object: "This is because people with equity in their homes have more at stake in avoiding default."

That is just patently untrue. If I have equity in my home—that is, a Loan to Value (LTV) of materially less than 100%—then there will not be a "default." I may have to sell the home, but my creditors will be paid in full and, net of transaction costs (e.g., moving expenses), I will be materially worse off only in the sense that the new residence is less utile than the old.

The "moral hazard" here is not with the borrower, who does what he or she can to preserve their way of life. Instead, it is with the lender, who recognizes that the collateral offered will more than compensate them if the loan is defaulted.

This has nothing to do with "their borrowers’ financial circumstances." Financial institutions support MEW and HELOCs and the like because they present them with relatively low risk for a relatively high gain, regardless of the borrower's financial situation.

If Ben Bernanke wants to pretend otherwise, he's not doing so for economic reasons.

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