06 March 2008

What to Do about Foreclosures?

CNN reports that foreclosures are at an all time high in the U.S., with 2% of all U.S. mortgages being in foreclosure.
The specter of 2% of homeowners losing their homes is ugly. While I'm not in that situation, my wife and I are currently struggling to pay two mortgages because in Michigan's current state, our first house won't sell for anything close to what we owe on it. The real problem, though, is the subprime adjustable rate mortgage market. The question is, what should be done?

The natural response is to say that government should bail people out. After all, one of its responsibilities is to provide a safety net for the unfortunate.

But that easy answer ignores the type of incentives created when government intervenes in the market. Two groups of people made mistakes in this case, those homebuyers who got subprime mortgages even though they weren't going to have the ability to pay the higher rates when they went up, and those mortgage companies who extended loans to people who wouldn't be able to repay them.

I don't think it's possible to help out the homeowners without helping out the lenders, and therein lies the problem. Government bailouts create a moral hazard--they encourage further risky behavior by the companies that are bailed out, because it leads them to expect government will protect them from their mistakes. The best long-term solution is to let the lenders suffer, so they'll be wary about making such foolish business decisions in the future.

But politicians can't afford to think that way. It's foolish to think that government does a better job of looking to the long run than businesses, because politicians have to get re-elected this fall, not years down the road, and what better way to show voters you're working for them than by keeping them from being thrown out of their house?

The really perverse thing is that by helping people now, the government makes it more likely they'll have to help them out again in the future. That is, many of government's efforts to "stabilize" the market actually make future instability more likely, necessitating future government intervention, etc., etc.


James K said...

Its worth remembering too that homeowners are on average richer than the general population so you would expect bailout sot be a regressive transfer, so bailouts may be inequitable as well as inefficient.

The best thing to do here is nothing. Some people will suffer, but that is best handled by the welfare system, not by special intervention.

James Hanley said...

That's a good point. The problem here, however, is mostly subprime loans, which leads me to think that the homeowners (or would-be homeowners) in question here aren't necessarily the well off, as a general rule.

However that's an empirical question, for which I don't have any data. I can easily see an upper middle class family getting a subprime loan so they can get a newly built 3,000 square foot house instead of a 135 year old 1,500 square footer (i.e., my house).

Now you've made me think, dammit! And I'm not sure where to find that information. Too bad, because it would make a great op-ed.

James K said...

Subprime borrowers may not be rich, but I'll bet they're richer than the people who can't even get subprime loans. Sure some people can afford a house but don't buy one, but I'm not sure they're a big group.

Down here the market is still running white hot so the buzzword of the day is affordability. Since I work in housing policy the housing market occupeis quite a lot of my work time. I'm hoping the market tanks, it'd certainly save me a lot of work ;)

That, and I'd actually like to able to affor dto buy some day,a nd int he current market that just won't happen.

James Hanley said...

Housing policy, eh? Well, then I'm certainly going to take your arguments on this thread seriously. Can't say it's ever been one of my specialties, although I've always found it a very interesting topic. I've rarely gone much beyond comparing the market-based housing system in the US with the government-based system in Sweden.

James K said...

I haven't had a chance to look at your situation in detail, our problems are rather different, but I am pretty confident that homeowners (even the ones facing foreclosure) are not the first group that requires government assistance, especially if the measures taken hold house prices up. After all, a mortagee sale can be an opportunity for a poor family.

James Hanley said...

Good points. I agree that, even if those affected by the mortgage crisis are not the well-off, they certainly are not the poorest among us, who are most in need of assistance.

But in the United States, the term "middle class" has a huge amount of political clout--so if "the middle class" gets hurt, it's a good bet our elected officials will do something, whether or not they should.