Human Events, August 2, 2007

It's never a pretty picture when investments go bad. So it is with so-called "subprime" mortgages made to borrowers with imperfect credit.

Losses are mounting and some lenders are looking for a bailout. Government should say no.

A mortgage to the average middle-class homeowner is a safe investment. But that security means the rate of return is modest.

So some investors lend to homebuyers with credit problems who aren't eligible for conventional mortgages. The default and interest rates both are higher.

During the recent real estate boom cash poured into the subprime market. Many of these mortgages were bundled together into collateralized debt obligations (CDOs).

Roughly $320 billion worth of CDOs were issued last year alone. Some hedge funds have heavily invested in CDOs.

Mutual funds, representing middle class investors, also jumped into the subprime market. Individual funds, such as those managed by Regions Morgan Keegan Select, sunk a significant share of their money into CDOs.

So long as home prices were rising, everyone seemed to benefit. If a homeowner got into financial trouble, he could sell or refinance. But no longer.

Housing prices are stagnating, lenders are tightening terms, home defaults are climbing, foreclosures are increasing, lenders are going bankrupt, and CDOs are taking a hit. Indeed, Jeffrey Gundlach, chief investment office of TCW Group, has termed subprime lending as an "unmitigated disaster." Moody's Investors Service has been downgrading some CDO investment scores and placing other mortgage-backed securities on its watch list.

All of this should be unexceptional. After all, every day the bond and stock markets generate losers as well as winners.

But with losses that Deutsche Bank AG estimates could hit $90 billion, most everyone in the market is busy looking for other parties to blame--and sue. Homeowners and investors are accusing lenders, mortgage companies, rating services, and banks of everything from racial discrimination to misrepresentation.

Homeowners and investors also are looking for a government bailout. Federal financial regulators have issued new guidelines intended to discourage many subprime loans.

Legislation has been introduced in Congress to set licensing standards and create a national database for mortgage brokers and other sellers of home loans. Money would be provided for federal foreclosure prevention efforts and private groups offering homeownership counseling. The government also would restrict the terms of subprime mortgages.

Some officials propose a forthright taxpayer bailout of homeowners, lenders, and investors. For instance, Massachusetts Gov. Deval Patrick is pushing Senate Bill 2296, a $250 million fund to underwrite refinancing for troubled homeowners. Other analysts prefer the federal government to take the lead.

More effectively regulating predatory lending and abusive speculation is a worthwhile goal. However, it is important not to protect those who created the problem from the consequences of their own mistakes.

Even bailouts formally directed at homeowners also subsidize mortgage lenders and Wall Street investors. The latter groups have the most at risk when homeowners are stuck with difficult-to-sell homes worth less than the loan amount. In effect, taxpayers, including many of modest incomes who chose to live within their means and rent, would be subsidizing their more profligate compatriots and some of the nation's wealthiest financiers.

This isn't the first time that taxpayers had to dig deep to bail out investors seeking extra profits. Paying off the Savings and Loans cost taxpayers about $124 billion.

There might be an argument for another round of perverse wealth redistribution if the economy was at risk, but subprime lending comprises only a tiny portion of mortgages, let alone the nation's overall financial resources. Treasury Undersecretary Robert Steel told a congressional committee that the subprime downturn "does not seem to be a systemic issue." People are losing money and the market is adjusting, as it routinely does.

A bailout would be foolish as well as unjust. It would encourage irresponsible behavior by borrowers, lenders, and investors throughout the economy.

Free markets work so well because they hold people accountable for their mistakes. Allowing investors to keep their gains while handing their losses to taxpayers would subsidize irresponsibility. Protecting people who have taken a bad loan would encourage them to risk even more the next time they seek credit.

Saying no--to hurting homeowners and complaining investors alike -- isn't easy. But losses in the nation's subprime lending market are not the responsibility of taxpayers. We don't need another special interest bailout.