A subprime bailout or not?

This morning both Federal Reserve Chairman Ben Bernanke and President George W. Bush addressed the subprime lending problems and what the government would and would not be doing. Both said it’s not the role of the government to bail out speculators and investors who made imprudent decisions, but . . .

Bernanke, in a speech delivered at the Economic Symposium of the FRB of Kansas City in Jackson Hole, Wyoming, said that the Fed “stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets.” He said:

It is not the responsibility of the Federal Reserve–nor would it be appropriate–to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy. In a statement issued simultaneously with the discount window announcement, the FOMC indicated that the deterioration in financial market conditions and the tightening of credit since its August 7 meeting had appreciably increased the downside risks to growth. In particular, the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally.

President Bush addressed the problems delinquent subprime borrowers are facing and said he will have the Federal Housing Administration guarantee some of those mortgage loans in arrears and help borrowers get refinancing at more favorable rates. The President said that “speculators” will not be helped by his plans.

The Fed Chairman’s speech also included a lengthy discussion of the history of mortgage lending in the U.S. through more recent developments of the secondary mortgage market and the commoditization of mortgages. He hinted that the current model will be changing though not reverting to the traditional mortgage model of portfolio lending where the lender retained the loan.

I have argued elsewhere that, in some cases, the failure of investors to provide adequate oversight of originators and to ensure that originators’ incentives were properly aligned was a major cause of the problems that we see today in the subprime mortgage market (Bernanke, 2007). In recent months we have seen a reassessment of the problems of maintaining adequate monitoring and incentives in the lending process, with investors insisting on tighter underwriting standards and some large lenders pulling back from the use of brokers and other agents. We will not return to the days in which all mortgage lending was portfolio lending, but clearly the originate-to-distribute model will be modified–is already being modified–to provide stronger protection for investors and better incentives for originators to underwrite prudently.

With both Bernanke and Bush somewhat equivocating about what will be done, it remains to be seen whether there will be a taxpayer bailout of borrowers or investors who made imprudent financial decisions.