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.