The general outline of a government-fostered plan to reduce defaults on adjustable-rate mortgages is emerging. Lenders would agree to freeze interest rates at current levels for those borrowers who have met loan payments to date and who can continue to make existing payments with their current income. Is this a good idea?
The answer is a definite maybe. The looming problem is severe. This may be a case where private markets fail to produce an optimal outcome for society. But any such plan necessarily will contain both inefficiencies and inequities. It may provide perverse incentives to many and may create other as-yet-unforeseen economic problems. We won’t have much clarity about the wisdom of the plan until after all the dust has settled.
The proposal reportedly does not involve any government spending. Rather, the Treasury Department and financial regulatory agencies would encourage voluntary action by private firms. To the extent existing law allows, regulations would be interpreted as liberally as possible to foster private action. Congress might step in to loosen some restraints such as tax treatment of foregone interest or forgiven principal amounts.
Conservative skeptics ask why government should act at all to protect either borrowers or lenders from the results of their imprudence. Liberal skeptics wonder if the intent or effect is to bail out avaricious lenders rather than help strapped households.
When evaluating the need for government involvement, economists begin by asking, Are private markets failing here? If so, the second question is, Will government action make the situation better or worse?
Governments fail when there is monopoly power or other lack of competition, when there is imperfect information available to private decision makers and when “external effects” are involved. Such externalities are costs or benefits to society as a whole that are not borne by either party to a private transaction. There also may be “prisoners’ dilemmas,” where market participants fail to take actions that are positive because of fears they will be undone by competitors.
Several such failures may be present here. First, investment banks and other holders of mortgage-backed securities obviously don’t have a handle on the risks they face. Credit markets are locking up as major companies sit on their hands.
Second, there are external costs to mass defaults on mortgages. If a hundred borrowers cannot pay their loans, they or the lenders involved may be hurt without affecting the broader community. But if a million such borrowers come up short, the effect may be to tip the nation’s economy into a recession, harming millions more who have no direct connection to the problem.
Finally, some mortgage originators and servicers or owners of mortgage-backed securities may be willing to alter loan terms but would be inhibited from doing so because of uncertainties about how their competitors may react.
One can thus make a reasonable case that we are in a situation where private markets are failing. The question of whether government action can improve things is knottier.
When there is insufficient information for private businesses to make good decisions, there often is not good information for government to make any better decisions. Government intervention that is poorly thought out often increases uncertainty rather than reduces it.
Government can reduce those uncertainties stemming from its policies. For example, it can clarify how far lenders may cooperate without violating antitrust rules or how the Internal Revenue Service will treat outcomes of alterations in loan terms. It can limit legal liability for investor losses that result from loan renegotiations.
The aegis of government sponsorship also can motivate broad lender participation by reducing fears that unilateral actions by any one lender will put it at a competitive disadvantage.
But the primary justification for government action in this case is that of external effects. History teaches us that when asset bubbles end in widespread financial defaults, the impact on broader economic activity often is severe. Bold action early on may forestall wider and deeper damage later.
That argument probably will carry the day. When society feels threatened, the “don’t just stand there, do something” impulse carries political weight.
But the fact that one can find justification for government action does not mean any government action will improve things. There is many a slip twixt the cup and the lip. Skeptics can list many ways in which a mass mortgage moratorium like the one under discussion might harm an economy. But that is a subject for another column.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.