Bailouts do not instill responsibility for consequences

By DAVID MOON, Moon Capital Management, LLC
September 28, 2008

As we learn more details about a federal mortgage and business bailout package, it becomes clear that the complicated collection of financial engineering has several aims.

One of the obvious goals is to help people and businesses that find themselves in difficult financial situations.

I received a note this week that read in part, 'The inability of the government to let a very large institution suffer the consequences of its acts reminds me of how parents do not want their kids to get hurt and they try to shield them from their own choices.'

Perhaps that sounds like a cruel, uncaring observation. It came from a member of the clergy ' someone who has spent a lifetime in low-profile, selfless service to others.

When investors and companies engage in capital-raising activities, they enter into contracts that are supposed to govern the relationships by specifying the rights and obligations of the parties. If one party doesn't like what happens, it still needs to live with the consequences.

The same goes for policyholders. And annuitants. And counterparties to credit-default swaps.

One of the goals of this package is to help homeowners in various ways. Since the federal government now controls Fannie Mae and Freddie Mac, do you really expect those entities to shrink? Can you think of a single entity (or person, for that matter) that has gotten smaller under federal control?

An investment analyst recently speculated that in an attempt to 'help' homeowners and spur the residential real estate market, Fannie Mae and Freddie Mac might eliminate the down payment on certain home mortgages.

That's like treating alcoholism with massive doses of bourbon.

Some of the intended protections for wounded financial institutions are equally suspect. There are laws against manipulating stock prices. If I buy or sell stocks with the sole intent toaffect the movement in a stock price, it is against the law. But limits and prohibitions on short selling ' which are among the latest federal rules ' are simply moves aimed at keeping stock prices from declining. It's reminiscent of Richard Nixon: 'It isn't against the law if the President does it.'

In the last couple of years, lenders have discovered that credit ratings are not the best predictor of whether or not a homeowner will default on his mortgage. The best predictor is the amount of equity he has in the home. Someone with a significant amount of his own money at risk will continue to make his payments, even if it hurts.

If he has nothing to lose, it's easier for him to walk away. He might actually be less willing to default on his bass-boat loan.

Psychologists tell us that the less willing parents are to let their children take instructive risks and endure the consequences, the less likely it is that the kids will become responsible adults.

Fortunately, parents don't depend on children to vote them into office, else every generation of new young adults would require a bailout of some sort.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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