Mortgage lenders and servicers face a classic ‘prisoners’ dilemma’ with mortgages headed toward default. Like small-time safecrackers being sweated in a precinct house, they know what course is best for them to follow — as long as they can trust the other guy to do the same. Absent that trust, however, they may follow incentives that will cause them pain but to which there is no better alternative.
The safecrackers know that as long as no one breaks under pressure, the case against them will go nowhere. But they are being grilled separately and offered the same deal: Confess and agree to testify, and the other guy goes up the river. Hold out, and you take the risk that the other guy sells you out.
The comparison with two thieves does not imply any illegal activity by mortgage lenders. It just means that they face the same quandary familiar to any student of game theory.
My point is rather that mortgage holders as a group would benefit from renegotiating many bad mortgages, accepting lower interest rates and even writing off principal, as Federal Reserve Chairman Ben Bernanke suggested this week.
Foreclosure is an extremely wasteful measure. The property usually benefits no one for months. Legal and administrative fees eat up cash. Both borrowers and lenders often end up worse off than if they had negotiated a shared loss.
Moreover, widespread foreclosures hurt society as a whole. The more properties in default, the farther house prices drop.
The more households in bankruptcy, the lower consumer spending. The more mortgages written off, the worse the profitability of mortgage lending. The more mortgage-backed securities that go sour, the worse the financial condition of pension plans and mutual funds.
As Bernanke put it Tuesday, “Reducing the rate of preventable foreclosures would promote economic stability for households, neighborhoods and for the nation as a whole.”
But if voluntary mortgage relief would be so beneficial, why isn’t it happening? Lenders all fear that if they go ahead but the rest of the industry doesn’t, they will be at a competitive disadvantage. We are living out the old gag of Alphonse and Gaston, who stand by a door endlessly repeating, “After you.” “No, after you.” “No, I insist, after you.”
The prisoners’ dilemma is not the only economic phenomenon here. Information problems also abound. When local banks made home loans to their own customers, and held on to the mortgages, they had both the information and the incentive to renegotiate terms when appropriate. But now mortgage lenders often resell the loans, and the new holders of the debt may not have anything more to do with the borrowers.
Securitization, intended to spread mortgage risk to those most willing to be paid to bear it, cut the links between borrowers and lenders.
Indeed, the office to which borrowers direct monthly payments usually is just a lockbox service performing routine administrative duties for many different mortgage lenders. Borrowers seeking relief often run into a brick wall trying to locate someone with whom to negotiate.
The nation is transfixed by a fallacy of composition. What may be good for any single mortgage lender — recovering as much money on each loan as possible and avoiding loan write-offs for as long as possible — is bad not only for the mortgage industry but also for the nation as a whole.
Why can’t government act to break the log jam? Unilaterally intervening after the fact to void legal contracts made between willing individuals creates more problems than it solves. That is why calls for government-mandated moratoriums, interest freezes and principal write-downs are a bad idea.
Trying to solve some of the information problems is a better idea, particularly if it facilitates lenders and borrowers finding out exactly who their counterparties are. There are several proposals before the Legislature. Some order the tide not to come in. But others have the potential for reducing information problems. Those are the ones to consider.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.