Mortgage defaults have increased for more than a year and will get worse before they get better. Americans cannot see a problem without feeling we must solve it. That is true with subprime mortgages and other foreclosures. There are recurring proposals at the state and federal levels for government to bail out borrowers in default facing foreclosure. Doing so would be a mistake.
Earlier this year, the Ohio Housing Finance Agency borrowed $100 million to spend on “emergency refinancing” of borrowers who are in default. Minnesota officials considered a similar program, but no action has been taken so far. But similar proposals keep resurfacing here and elsewhere. Some members of Congress have floated trial balloons for a federal program.
The impulse to help those in trouble is a human one, but impulse is seldom a sound basis for economic policy. The problem right now is that it is difficult, if not impossible, to bail out borrowers without bailing out lenders. Moreover, such bailouts usually delay necessary adjustments – in this case of house prices – that need to occur.
People who bought houses – or refinanced debt – with adjustable interest rates made a bad decision. So did those whose loan applications obscured their true ability to service debt. So did lenders who made unsuitable loans. These lenders sought to pass the risk on to those who bought securitized mortgages.
Someone must be hurt as a result of these bad decisions: the borrower, the lender or the mortgage-buying investor. We can shift some of the loss to taxpayers, but it is next to impossible to ensure that the borrowers benefit, but not the lenders.
That was true in various state responses to the farm debt crisis of the 1980s. It was true in Japan after its property bubble popped in 1989. It was true in the bailout of Mexico in 1995 and the 1997 Asian financial crisis.
Despite claims that “emergency financing” can be structured so that mortgage originators or investors don’t share the benefits, this is nigh impossible. If a government agency helps borrowers pay debts they could not otherwise pay, then lenders get payments they would not otherwise get. That reduces their losses.
Moreover, bailouts are freighted with moral hazard. It sends the message to future lenders and borrowers that if they make bad financial decisions, government will inevitably ride to their rescue.
Preventing foreclosure eases pain for some households, but it delays adjustments in housing prices that inevitably would occur in the absence of a bailout. If Japan’s experience in the 1990s taught us anything, it is that government propping up of property prices after a bubble just prolongs pain and stagnation.
Defaults on existing mortgages are spilled milk. Better to channel our energy into ensuring that similar sprees of imprudent lending and borrowing do not occur again. Putting public money into “emergency refinancing” is not the way to do that.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.