Weathering the subprime crisis; Should government intervene?

Chief Executive, The, June, 2008 by Richard A. Epstein

Bad Medicines

The various relief programs can only prolong the agony. Thus any suggestion to suspend foreclosures for 90 days leaves debtors in possession of property while it is still under water. One possible consequence is that the defaulting owners will no longer take care of the property, resulting in still greater losses when foreclosure eventually comes. The upshot could be further losses on both sides, for no good public purpose.

Nor is the situation made any better by passing laws that lock in those low teaser rates on subprime mortgages for, say, a five-year period. Put aside the serious constitutional questions of whether Congress or the state can meddle in contract terms, without compensating lenders for the increased risks they are forced to bear. Unfortunately, no court can mitigate the economic dislocations that follow once the scheme is put into place. What is a gain to the borrower is a loss to the lender.

The reduced cash flows could easily impair bank balance sheets, causing share prices to tumble, there-by hurting all individuals, including those who did enter into these risky subprime mortagaes. Nor is there any guarantee that these mortgages won't turn bad down the road if the hard economic times continue. Prolonging the agony is more likely to lead to further decline in property values and additional economic insecurity.

Worse still are the various proposals to inject public money into this unstable situation. One proposal is to create government funds, to the tune of $30 billion, that can buy foreclosed properties in distressed neighborhoods. Another is to have government guarantees on loans, so long as the lender writes them down by, say, 15 percent. Don't do it. Those revenues to fund these dubious social investments have to come from someone, and the additional tax burden could well put additional pressures on responsible borrowers and renters to fund the mistakes of their more reckless neighbors. Nor is there any reason to create a political brawl to see which properties are given relief and which ones are not. No government program can avoid the favoritism that always comes when large goodies are given away at below market rates.

It is an even worse idea to create any special funds--to the tune of $10 billion-to help first-time home buyers borrow money at below-market interest rates. The need for these mortgage subsidies would vanish if foreclosed properties were allowed on the market at lower prices. But put this program into place, and we can be confident that lenders will be content to shovel money out the door, knowing that Uncle Sam is on the hook.

Why invite yet another round of dislocations down the road? The simple but powerful point is this: The losses that have been incurred won't disappear by government gimmicks. The only way in which the housing industry can return to prosperity is for builders, buyers and lenders to go forward on a sound and self-sustaining path.

The current stopgaps only spread the pain, by forcing prudent individuals to bear the costs of their less-prudent fellow citizens. Government action may be good politics, but it is bad economics that all CEOs should avoid.