The sub-prime and overall mortgage carnage is now likely to lead to a financial crisis whose cleanup and bailout costs will make the S&L bailout bill look like spare change. We are only at the beginning of this fallout but, already, several proposals and bills in Congress have been submitted to help millions of sub-prime homeowners on the verge of bankruptcy and foreclosure. The prospect of millions of homeowners thrown homeless on the street is already shaking politicians of every stripe. The relatively modest bailout envisaged by the first bills currently proposed in Congress will mushroom into a much bigger fiscal bailout of homeowners, borrowers and lenders once the garbage of sub-prime, near-prime and pseudo-prime toxic waste spreads around the economy and likely leads to a hard landing recession that will cause a much bigger financial and banking crisis.

Given the fallout and real, social and financial costs of this disaster the political blame game will soon start. So it is important to make sure that the self-serving spin game that accompanied the game of those who happily ignored since last summer the looming housing, mortgage and economic mess will not be repeated again. Powerful political and financial interests will spin their self-serving ideological spin on who is to blame for this mess. Specifically be ready for a cabal of supply side voodoo ideologues - from the Wall Street Journal editorial page (and its invited op-ed writers) to hacks (calling them economists would be an insult to my profession) such as Arthur Laffer, Steve Hanke and other assorted voodoo religion priests - to start spinning a tale blaming government regulation and interference for this disaster that has instead its core in the lack of sensible government regulation, not the existence of such regulation.  In the meanwhile powerful financial interests that repeat the mantra – or better the proof-less dogma - of unregulated free markets and do not like any – even sensible – supervision and regulation of the financial system will happily blame government action – rather than their own reckless greed and stupidity - for this disaster while happily demanding and receiving billions in bailout funds from the same government that they so happily disdain. This will be the most appalling form of corporate welfare: privatize the profits in good times and socialize the losses in bad times.

This fairy tale spinned by free market supply side voodoo fundamentalism zealots will blame the otherwise appropriate current Congressional action on predatory lending for being one of the main causes of the credit crunch that will lead to a painful recession (as the WSJ editorial page recently claimed) while forgetting that predatory lending practices developed by free unregulated markets created the toxic waste that is subprime and near-prime mortgages.. This voodoo religion cabal will also incorrectly blame regulators –  whose true blame was being asleep at the wheel for six years while being drugged by a philosophy of “laissez-faire” non-interference with free markets while this free market garbage was being originated – for now finally starting to crack down on monstrous “free market” practices such as zero downpayments on mortgages or NINJA (No Income, No Jobs and Assets) loans; this cabal will thus now blame regulators for “destroying” the sub-prime and near-prime mortgage market with their intervention into “self-regulating free markets”. The same voodoo economics religion priests has and will incorrectly blame the “easy” Fed monetary policy – rather than the lack of any sensible regulation of credit and mortgage market lending – for creating the housing bubble and letting it fester for too long.  It will also incorrectly blame the GSEs for creating “moral hazard” via guarantees of mortgages and thus causing this mess when, instead, the GSEs largely got out of the subprime business in the last few years - and let the free market flourish to originate this toxic waste – when politicians and policy makers started to bash the GSEs for their “excessive” role in the mortgage market.

Since a lot of nonsense and financially self-interested ideological spin will be written and said in the months and years to come it is important – from the beginning – to be clear about who is at fault for this utter housing and financial disaster. The answer is clear: the blame lies with free market zealot and fanatics and voodoo economics ideologues who captured US economic policy in the last six years in the same way in which a bunch of neo-cons high-jacked US foreign policy to bring “democracy” to the Middle East while instead leading the country into the Iraq and Mid-East quagmire and now disaster.

According to these ideologues – listen for example Larry Kudlow extolling every evening on CNBC the virtue of unregulated wild-west cowboy capitalism - government is always utter evil and the economy could never have a financial or economic crisis if taxes are low, government spending is minimal and government intervention and regulation of the economy and of financial systems is inexistent. This nonsense about bubbles, financial crises and recessions being impossible unless the government over-regulates the economy and/or makes monetary policy mistakes is the main religious dogma of this cabal, an axis of ideological zealotry that goes from the WSJ editorial page to a gang of voodoo economic hacks and to some segments of the financial television.

The truth is the contrary: unregulated free market capitalism that has no sensible rules, regulation and supervision and sensible countercyclical monetary and fiscal policies of financial markets leads to credit and asset bubbles, financial excesses and economic and financial crashes. Economic and financial booms and busts were much more severe in the US in the 19^th when there was no central bank and no welfare state fiscal actor trying to fine tune the economic business cycle. And business cycle swings have become less frequent since Keynesian countercyclical use of monetary and fiscal policy has been introduced from the Great Depression on.

The reality of the last three US recessions – the 1990 recession, the 2001 recession and the coming 2007 hard landing – is that each of these recessions started when the government stopped regulating and supervising in moderate and sensible ways financial institutions and allowed credit and financial and investment bubbles to rise and fester until they ended up in bursting bubbles and leading to recessions.

Take the latest subprime and mortgage disaster: the WSJ editorial page will certainly in due time blame the coming recession (that it now happens to predict as likely) on Congress meddling with markets on predatory lending, on excessive regulation of what financial institutions do and on the moral hazard evils of expected bailouts of mortgage lenders and borrowers. But this argument is confusing totally cause and effect. The housing and mortgage and subprime bubble and bust did not occur because of government interference and regulation of free markets. It did instead occur because government regulators were asleep at the wheel while a bunch of voodoo priests of laissez-faire capitalism were running US economic policy and let the housing and mortgage bubble fester. Blaming the now too late government crackdown on free market mortgage practices that were utterly reckless for the final bust and crash is like blaming the doctor for imposing bitter medicine to cure the disease of a  reckless patient who lived in a bubble and spent the last few years on a diet of booze, drugs and artery clogging junk food. This latest mortgage carnage did not happen because of excessive over-regulation of markets by the government: it happened instead because – blinded by the anti-regulation dogmas of a bunch of priests of a voodoo religion – the government and regulators did nothing to sensibly regulate the housing and mortgage market and thus allowed this cancer to grow and fester.

Booms and busts are regular features of market economies that do not have sensible government supervision and regulation of financial and credit markets. The S&L crisis that led to the credit crunch that caused the 1990 recession started when previously regulated S&Ls were deregulated and there was no sensible supervision of their activities while deposit insurance led them to “gambling for redemption” reckless lending. And blaming  “evil” government-provided deposit insurance for their moral hazard gambles is again confusing cause and effect: financial institution that do strictly need deposit insurance to avoid free-market capitalism liquidity and bank runs during panic episodes do require sensible government-imposed and monitored capital adequacy ratios as well as supervision and regulation of their lending activities to avoid moral hazard-induced distortions in their lending behavior. It is not government-generated moral hazard via insurance that lead to reckless gambling for redemption: it is the lack of sensible government-based regulation and supervision that leads to credit and asset bubbles.

In the 1980s this deregulation of S&L then led to a real estate bubble – both in commercial and residential real estate in the South of the US – that ended up in a bust once a glut of shopping strips, shopping malls, office centers, and residential homes piled up as a result of unregulated credit creation by the S&L. Then, the ensuing credit crunch – rather than the necessary but late government intervention to control this free market made disaster – led to a painful recession in 1990-1991, a systemic banking crisis and a bailout of these S&Ls that ended up costing the US Treasury – or better the US taxpayer – about $200 billion. Unregulated wild-west capitalism without rules and regulations was the cause of the S&L boom and bust, not the eventual government intervention to deal with this mess as the priests of the free markets voodoo religion would want you to believe.

Similarly, the last six years’ housing and subprime mortgage bubble and bust had little to do with excessive government intervention – either ex-ante or ex-post. Instead they had all to do with the lack of any basic sensible government regulation of the mortgage market, regulation in practice rather than in theory. Dozens of new subprime lenders emerged and were allowed to lend via monstrous credit practices – liar or NINJA loans, no down-payment loans, interest rate only loans, negative amortization loans, teaser rates, option ARMs with no limits or controls  - that should have never been allowed in the first place. Even now that regulators are starting to crack down on the most patent monstrosities such as zero down-payment and no documentation of income, jobs and assets the voodoo priests and their acolytes in the mortgage industry are starting to blame the government for interfering with free market practices: in their ideological view there were optimal reasons for all of such practices: in market fundamentalism if such practices emerged there was a good reason for them and now the government interfering with these monstrosities will cause a credit crunch that will damage the mortgage market and cause a nasty credit crunch that will lead to an economy-wide recession. What a bunch of nonsense and self-interested baloney!

These practices instead emerged because the voodoo free market system of financial incentives for lenders –  deceive borrowers with predatory practices, originate reckless mortgages to pile up fees, then securitize those mortgages and shove them on some other investors who had no clue of which toxic waste they were buying – became a whole con scheme. The way a senior and unnamed market participant put it in a bit exaggerated terms this was “an unregulated scam where a bunch of con artists fooled a bunch of clueless deadbeat borrowers”.

So do not blame excessive government regulation; it was the lack of any basic regulation that created the bubble.  Do not blame Congress for being the cause of the coming credit crunch because of it totally appropriate predatory lending investigations and soon legislation. If such legislation will lead – as some recent analyses have suggested to the disappearance of one third of the subprime mortgage market, so be it as part of these subprime loans were deceptive, predatory and should have never been made in the first place. Lenders were systematically deceiving poor and uninformed borrowers, many of which minorities who had no clue of what they were getting into. Suppose you were a poor African American or Hispanic or a white poor with low income and no assets who wanted to pursue the American Dream of home ownership and you did not qualify for a regular mortgage because of your low income.  No problem – told you the mortgage broker – we will give you a NINJA (no income, no job and assets) or liar loan, i.e. a loan with no documentation of your income and assets.  You did not afford any down-payment because of little assets? No problem as we will let you to put zero down-payment so that you start with zero equity in your home. You could not afford principal payments? No problem as we will give you an interest only loan. You could not afford a fixed rate mortgage? We will give you a 2-28 ARM where the rate is fixed at low level for two years and then you move to much higher market rates. You did afford even that? We will give you a teaser rate for a little while. You could not afford even that? We will let you capitalize interest on a higher face value of the mortgage for a while so that you will have negative amortization and you pile up negative equity on your home from the very beginning.  And the poor, hapless and clueless borrowers said yes to all of this as the lender never told him that after two years its debt servicing rate would balloon by 500% once he/she had to start paying high market rates and principal on an ever increasing –not decreasing – stock of mortgage debt.  So do not blame Congress for necessary legislation on predatory lending for causing the current credit crunch; it was the lack of such legislation in the first place that allowed millions of mortgages that should have not been originated in the first place to mushroom without control.

Also, did the originators care or had any interest or incentive to warn the borrower that he/she could not afford such predatory and deceptive mortgages? No way as the originator would get very fat originations fees/commissions. then package this toxic waste into mortgage backed securities, get a nice rating on that garbage from oligopolistic credit rating agencies whose income derived from giving a high rating to this junk – under the pretense that tens of thousands of piles of toxic waste would turn by miracle into gourmet food – and then sell this securitized toxic junk as if it was fresh roses to even more clueless “savvy” investors desperately searching for yield and being dumbly ignorant of the risks that they were taking. These investors were not innocent victims; they were blinded by their own search-for-yield greed and did not bother to figure out non-transparent and totally opaque new financial instruments may be toxic waste.

Then this entire housing and mortgage and securitization bubble fed an entire industry of originators, brokers, banks, broker dealers who created and securitized this junk and created CDOs, synthetic CDOs,  CDOs of CDOs (CDO squared) , CDOs of CDOs of CDOs (CDOs cubed) and another totally not-transparent fog of credit derivatives – that were being priced based on intuition rather than true analysis of risk. These credit derivatives went, in less than a decade, from non-existent to a notional value of over $26 trillion. In the meanwhile this industry sold this garbage and provided financing for these investments as well as a variety of other prime broker services to a rising mountain of  thousands of hedge funds. The fortunes of some of these broker dealers were partly fed for a decade from lending to home builders, to subprime originators or originating the mortgages themselves, securitizing the mortgages into RMBS, creating and managing the CDOs (and all their endless synthetic and cubed variants of them), offering aggressive prime brokerage services to the hedge funds buying this toxic waste, as well as trading on their own accounts the variety of these new instruments. No wonder these broker dealers and large financial institutions stocks are now under pressure while their arguments that they are only marginally directly exposed to subprime sound so lame: they are directly and indirectly exposed to this toxic waste via a dozen of different channels.

Also, please do not blame the GSEs (Fannie and Freddie) for this mess even if the GSE do have very different problems that need to be addressed. The GSEs were bashed for years by Greenspan, Treasury, Bernanke and a wide variety of observers for their excessive size and role in the mortgage market (securitization and guarantees of mortgages), for how they were managing their risks and for the potential moral hazard deriving from an alleged implicit bailout guarantee that allowed them to borrow at quasi-sovereign rates. Indeed some of these critiques of the GSEs do have some merit.

But the paradoxical effect of the backlash against the GSEs has been that in the last few years these institutions have significantly reduced their role in securitizing and guaranteeing mortgages. Specifically Fannie and Fannie significantly reduced their presence in the MBS market, especially among subprime mortgages and the MBS related to them. Reacting to the persistent arguments from many fronts that the two GSEs should reduce their role in the MBS market, in the last few years the job of originating and securitizing subprime mortgages and many near-prime mortgages was mostly taken over by private sectors institutions. As the GSEs got out of this business, subprime lenders and other major financial institutions originated sub-prime and near-prime mortgages, repackaged them and securitized into MBS then sold to investors and to CDOs. So, the growth of subprime and near-prime toxic waste had little or nothing to do with the role of the GSE in the mortgage market. Fannie and Freddie may have many faults but this subprime disaster is certainly not one of them. So beware of misleading attempts to blame the GSEs and moral hazard distortions from their perceived semi-public status in contributing to this subprime and mortgage disaster.  

The paradox is instead the fact that pulling the GSEs from any role in the subprime market allowed the “free market” to develop the excesses and monstrosities that the rise of subprime and near-prime mortgages generated in the last six years. It was the absence of the GSEs from this market, not their presence that contributed to this mess; and it was the presence of an unregulated free market system that allowed this monstrous bubble to be created, to be allowed to fester and to now burst with the nasty collateral damage that is coming with it.

Given the total lack of a role of the GSEs in this subprime and near-prime disaster it is really paradoxical that Bernanke, in his speech last week about the GSEs, pushed for reducing further their financial portfolios and recommended that the main role that they should have from now on should be the one of help support “affordable housing”, i.e. originating or underwriting and securitizing subprime mortgages. After years of ideological battles against them and after they moved out of the subprime market, and after the unregulated free market was allowed to develop the subprime market and create the toxic disaster whose collateral damage will now be paid by the US taxpayer Bernanke is now telling us that the subprime mortgage business (“affordable housing”) should not be managed by the private sector but should instead be fully given to the GSEs. He formally fudged the proposal by saying that greater role of GSEs in affordable housing finance does not mean a greater role in the subprime market. But he contradicted himself: having GSEs having a center role in affordable housing means a central role in securitizing subprime mortgages. This is the same ideology that led to the subprime disaster in the first place: privatize the profits of greed and unregulated gambling for redemption; and socialize the costs and losses when disaster from free market fundamentalism occurs. This is outright corporate welfare chutzpah.

Also, it is now clear that making subprime loans is clearly not an economically rational business for the private sector given the current subprime disaster. However whether Fannie and Freddie should do it instead or not is not obvious. If there is a role for the government in this markt then one may want to tax those who can afford to finance the subsidies for affordable housing. So Bernanke wants to reduce the GSE's interference with free markets by giving them and the public sector a greater role in affordable housing. But if the GSE have to do - and be perceived as doing - business as private sector firms that do not benefit from moral hazard related government how can they subsidize affordable housing and make a profit? If they get a role in affordable housing effectively Bernanke is telling us that they are public institutions, not private ones. So implicitly Bernanke is undermining all his attempts and those of others to make the GSEs truly private institutions that are not perceived as being protected by a Treasury bailout guarantee.

The same free market fundamentalist zealots – at the WSJ editorial page, among voodoo economics hacks and among the policy makers that mis-managed US economic policy for the last few years – who bashed the GSEs were also pushing the other mantra of the benefits for growth of low taxation of capital. But take housing. The taxation of investment in housing – an effectively unproductive form of capital - not only is not heavy; it is rather tax-preferred relative to other productive forms of capital. The zealots who want low taxation of capital got it all in the tax-favorite status of housing investment by households. The result has been another monstrosity: a decade of massive overinvestment by the US in one of the most unproductive forms of capital, housing. This overinvestment fed by low taxation of housing investment has led to large current account deficits - via the increase in housing investment and the fall in private savings that the housing wealth effect had on consumption - and to the accumulation of trillions of foreign liabilities. So instead on increasing its stock of productive physical capital the US has spent a decade piling up trillions  of dollars of investment in unproductive housing capital that has no effects on the rate of productivity of the economy. The rest of the world spent the last decade investing in factories that produce world class, high-quality and low costs goods; the US invested in McMansions that have zero productivity value and spillovers for the economy. Again thank the free market fundamentalist zealots who love no regulation and little taxation of capital for this sorry state.

The same free market zealots have now started to blame the Fed for causing the housing bubble. In their view the Fed, by aggressively easing rates after 2001 and keeping the Fed Funds rates too low for too long, created the housing bubble that is now bursting. So they blame the Fed for a disaster that had its source in the private sector behavior and actions. The same free marketers argue that the Fed created the tech bubble that burst in 2000 and led to the 2001 recession.

But while easy Fed policy had some role in the three private sector bubbles of the last two decades that ended up in a recession bust -  late 1980s real estate bubble that led to S&L bust and 1990s recession, the late 1990s tech bubble that led to the 2000 tech bust and the 2001 recession,  the 2000s housing bubble that led to the housing bust of 2006 and the coming recession of 2007 – the center of the problem  in each one of these three booms and busts was not – as voodoo religion hacks and zealots spin it now - excessively easy monetary policy by the Fed but rather proper regulation of financial and credit markets.

The center cause of these disasters was the lack of appropriate regulation of free markets. First, in the 1980s S&L were deregulated and wild-west capitalism became the norm of the credit policies of the S&Ls in the South and South-West of the US: then, a bunch of greedy cowboys and at time criminal con artists high-jacked the credit policies of the S&Ls and triggered a private sector real estate boom that, like today, created a massive amount of  toxic waste in real estate. This toxic garbage then exploded in the late 1980s in a nasty bust that triggered a credit crunch that was the main cause of the 1990-91 recession.

Second, in the 1990s, the attempt to avoid the liquidity run and crunch caused by another unregulated private sector-related reckless leverage – the near collapse of LTCM and its collateral damage – induced the Fed to ease the Fed Funds rate by 75bps in the fall of 1998 and let the tech sector “irrational exuberance” - that Greenspan had already identified in 1996 - to fester even longer. But higher Fed Funds rates would have not stopped this private sector crazed mania. What was necessary then was again better regulation of the financial system: much tighter margin requirements on leveraged stock market investments; control of leverage in the financial system and among highly leveraged institutions such as hedge funds. Failure to implement sensible regulation – such as margin requirements on leveraged tech investments - allowed the tech bubble to fester, then go bust in 2000-2001 and cause a painful recession in 2001 .

Third, this time around it is not true – like the WSJ editorial page has repeatedly and wrongly argued – that the housing bubble was mostly caused by a Fed that kept the Fed Funds rate too low for too long. Higher interest rates sooner would have made only little difference, especially in a world where long rates and mortgage rates depended more on global factors - that kept such rates low - rather than on monetary policy. The central Fed failure was not that of keeping the Fed Funds rate too low for too long (that was only a modest misdemeanor)  but rather its failure (as well as that of other banking regulators) to control the credit bubble in the housing market via appropriate supervision and regulation of mortgage finance and via prevention of monster lending practices.

Greenspan allowed the tech bubble to fester by first warning about irrational exuberance and then doing nothing about via either monetary policy or, better, proper regulation of the financial system while at the same time becoming the “cheerleader of the new economy”. And Greenspan/Bernanke allowed the housing bubble to develop in three ways of increasing importance: first, easy Fed Funds policy (but this was a minor role); second, being asleep at the wheel (together with all the banking regulators) in regulating housing lending; third, by becoming the cheerleaders of the monstrosities that were going under the name of “financial innovations” of housing finance. Specifically, Greenspan explicitly supported in public speeches the development and growth of the risky option ARMs and other exotic mortgage innovations that allowed the subprime and near-prime toxic waste to mushroom.

In a world where the leading ideology was to reduce regulation to a minimum, not only closing one’s eyes on monster lending practices but rather actively praising them as brilliant financial innovations, bashing GSEs in the name of letting the superior private sector to take a bigger role in monster housing finance, it is not a surprise that the biggest bubble in U.S. history was created, incentivated and allowed to fester until it imploded. Free market fundamentalist zealotry that did not understand that market capitalism needs some basic and sensible rules, regulation and supervision to control excesses, bubbles, greed and investors’ manias and panics.

The political neo-con freedom and liberty fundamentalists deluded themselves that free elections and military invasions will automatically lead to democracy in the Middle East. Instead, their free elections and freedom-agenda ended up getting Hamas, Hizbollah and Shite fanatics to come to power in Gaza, Lebanon and Iraq and while destabilizing Iraq and soon a good chunk of Middle-East. In the same way the free market fundamentalism zealots deluded themselves that unregulated free markets and low taxes could never do anything wrong or harm. Too bad that unregulated free markets that systematically lead – as two hundred years of US economic history show - to bubbles that end up in busts and nasty recessions have been the source of the last two US recessions. The implementation of this ideology is also the source of the latest housing boom and bust that is already leading to a severe credit crunch in the mortgage market and that will lead to an economy-wide recession in 2007 that will be deeper and more painful than those in 1990 and 2001.

So it was a vast range of dogmas and free market fundamentalism pushed by a bunch of ideological zealots - that were handmaiden to financial interests that enjoy private profits in good times and corporate welfare paid by the US taxpayer when their free market greed and excesses lead to nasty financial busts - that created this disaster. It was not an evil, large and over-regulating government that created this disaster. It was instead an ideology and practice of unregulated free markets that fed this mess.

Now that the mess has occurred and the financial costs of widespread bankruptcies among borrowers and lenders will be severe the issue will be the one of how to clean up this mess by helping the true victims while not bailing out the true culprits.

The main challenge will be to help the victims of this disaster – those households that were duped into predatory mortgages and who are now unable to service their resetting ARMs – without bailing out the private “free market” institutions that created this mess in the first place. Market capitalism works if equity holders first and bondholders second take the losses of their own investment mistakes. So wide-scale public bail-out of financial institutions should be strictly avoided and minimized. The trouble is that when deposit-taking institutions fail because their net worth is negative (as a consequence of bad lending) deposit insurance limits the losses that can be inflicted on these effectively senior creditors of these banks. Thus first losses should be taken by shareholders and other unsecured bondholders and creditors of the banks. In the case of the subprime lenders until now the failures have been concentrated among institutions that relied on capital markets for funding, rather than on insured bank deposits. Thus losses can and should be allocated to owners and bondholders of these institutions with no use of public money to bailout anyone. However, we cannot exclude that in due time some commercial banks and other deposit-taking institutions will get into trouble and public money may be needed to clean up the balance sheets of such institutions.

Public funds to help borrowers should be used with care for several reasons. First, some forms of borrowers’ financial support end up bailing out also the culprits of this mess; thus, these specific forms of support of homeowners under financial distress should be avoided. For example, direct subsidies to households who cannot afford their now-reset and excessively high mortgage payments end up helping the victims as well as the culprits. Thus, this kind of support should be avoided.

Second, across the board support of all sub-prime borrowers would be inappropriate: while many borrowers were duped into predatory mortgages by lenders who did not explain to them what were the true terms of these loans, a minority of borrowers recklessly borrowed well knowing they could not afford the terms of the mortgage. They borrowed either gambling into capital gains that never occurred (speculative investment in homes) or planning strategic early default on their mortgage. The latter phenomenon is represented by the epidemic of early payments defaults that we have seem among some subprime mortgages: given the time that it takes to foreclose a home some borrowers intentionally took mortgages that they were not planning to service at all to enjoy the benefits of a few months of free rent of a home. However, these few deadbeat borrowers were able to dupe lenders because underwriting standards of originators were recklessly loose to begin with: anyone lying about their income, job and asset could get a mortgage.

The analysis above suggests some principles for the coming financial support that will be given with public funds to clean up the unfolding mortgage disaster. First, distinguish between true victims of predatory lending and deadbeat borrowers who were into early strategic default. Early payments default is a clear way to distinguish between inability to pay and unwillingness to pay. Also, means testing for financial support is crucial: low income and low asset households who were pursuing the American Dream and were deceived by lenders may deserve support. But subprime borrowers with higher incomes and/or assets do not deserve support and should be pushed into foreclosure if they are unable or unwilling to service their mortgages. Also, condo-flippers and other individuals who bought homes for speculative purposes such as speculating on price increases (i.e. folks who were not first time homeowners who lived in their homes) would get no financial relief at all and will be forced to foreclose if they are unable or unwilling to service their mortgage.  Second, financial support to households who were victims of predatory lending (and owners of overvalued homes whose value was incorrectly assessed as much higher than equilibrium) should take the form of reduced debt servicing (as in some recent proposals) rather than subsidies to borrowers; this to prevent the support of the borrowing victims from indirectly bailing out the culprits of reckless or predatory lending.

For example, suppose that the value of a home (with zero down-payment) has fallen 10% (following the current housing bust) and that the borrower cannot now pay the full value of the mortgage debt servicing payments that are now being reset at much higher interest rates. Then, if the borrower can afford a lower string of service payments  that, in NPV terms, is 10% lower than the initial terms of the mortgage (and equal to the true value of the home), the solution will be to allow a reduction of 10% (in NPV terms) of the debt-servicing payments for the borrower. Instead, a public subsidy to the borrower in the same amount would have the same effect on the borrower while bailing out a reckless or predatory lender. 

Suppose instead that the home value has fallen 10% but the household cannot afford even a 10% NPV reduction of the stream of debt payments associated with the initial mortgage (say at zero initial down-payment). Then, the household – duped or not – was buying a home with a bundle of housing services that was too large relative to its ability to afford it even after the value of the mortgage has been adjusted to the lower market value of the home. In this case if it takes more than a 10% reduction in the NPV of the debt payments to allow the household to be able (or equivalently willing) to afford the home. Thus, it make sense to foreclose the home and not provide financial support to the household: duped or not the household had bought a home whose real housing services were too large relative to even its ability to afford it at a reduced market value. Thus, financial support of the household is not warranted and foreclosure is a socially efficient solution. The bank should take the loss of a mortgage with a home value lower than the mortgage. And such household should rent a lower amount of housing services by renting a smaller home/apartment rather than own a home with a bundle of housing services that it cannot afford.

Finally, if deposit-taking institutions whose depositors benefit of deposit insurance go bankrupt (have negative net worth) because of housing related losses, equity holders should be wiped out first and unsecured bondholders should suffer next before any public funds are used to recapitalize and fiscalize the losses of the bank. This simple principle would minimize the fiscal costs of cleaning up distressed banks while minimizing the moral hazard distortions of deposit insurance.

In summary, lack of sensible supervision and regulation of banks, mortgage lenders and other financial institution – partly induced by an ideology of free market fundamentalism – has been the core cause of this private sector created disaster, not excesses of regulation or of government policy. Thus, to minimize the fiscal costs of cleaning up this mess, use of public funds should be carefully managed and targeted to help the true victims of this mess – borrowers duped by predatory lending practices – while avoiding any bail-out of the culprits of this mess. Privatizing profits in good times while socializing losses in bad times is another form of reckless corporate welfare that generates moral hazard while fostering new bubbles.  Ideological supply side voodoo zealots should not be allowed to spin a tale where evil government intervention caused this disaster. And the private sector institutions and investors that indulged in this unregulated reckless behavior should take their losses. Market economies are the best economic system but they work properly when private greed, manias, panics, stupidity and recklessness is tempered by sensible supervision and regulation. And may the unfolding mortgage disaster bury once and for all the neo-con supply side voodoo economics religion of unregulated free markets fundamentalism.