The Subprime Mortgage "Crisis" Will Fix Itself
Hardly a day goes by without someone's proposing how to make the bad situation in subprime mortgage lending even worse. Legislators at all levels of government are contending for ownership of the most destructive idea. (One example of a thousand)
Finalists in this legislative race to the bottom include punitively stiff lending standards, foreclosure holidays and taxpayer-financed bailouts. I would like to propose a far simpler, fairer and effective course of action: let free people sort it out for themselves.
Let contractual arrangements remain in force, let good lenders prosper and bad ones suffer (similarly with borrowers) and let the taxpayers' pockets go unpicked. Legislative interference with market processes is likely only to prolong and deepen the downturn.
Legislators presiding over the subprime crisis hearings should look in the mirror and pose a few hard questions before assigning all blame to "predatory" lenders and mortgage brokers. Would we be talking about a "crisis" today if the Federal Reserve had not embarked on unprecedented monetary and credit expansion, in the process inflating a housing bubble of epic proportions similar to the late '90s Internet bubble? Isn't the entire housing edifice built on shaky foundations since Freddie and Fannie enjoy a protected lending status with all sorts of moral hazard implications? Wasn't it former Federal Reserve Chairman Greenspan who not long ago urged borrowers to shift to variable rate debt, most of which is now resetting at a perilously higher level? Is entrusting a solution to Washington putting a fox in charge of the chicken coop?
Regardless of where blame resides, the legislative options being considered are bad economics and ethically flawed. A bailout is nothing less than a wealth transfer to those who made ill-advised credit decisions from creditworthy, fiscally responsible taxpayers. A bailout postpones hard choices into the future and props up faulty credit. Individuals facing default or delinquency have less reason to curb spending habits or make other sacrifices. Lenders have less incentive at the margin to tighten credit standards if a bailout is imminent. Bailout logic is perverse, especially in light of growing evidence that a not-insignificant number of subprime defaults involve so-called "liar's loans", i.e., loans to borrowers who falsified information about their financial condition and income. Bailing out such borrowers is akin to rewarding them with a one-way free option on rising home prices.
Foreclosure holidays are equally flawed. Such laws in one fell swoop eviscerate contractual agreements and contravene the impairment of contracts clause of our Constitution. Unfortunately, that constitutional protection has been stripped of its teeth for generations.
Putting aside these legal quibbles, foreclosure holidays will lead to more foreclosures. Borrowers on the verge of delinquency will be less motivated to exercise fiscal discipline if they know that foreclosure rights are honored more in the breach than the observance. Lenders, less secure about their ability to take hold of collateral, will be less willing to lend, narrowing the refinancing options available for stretched borrowers. Ergo, foreclosure holidays will lead to more delinquencies and foreclosures just as banking holidays in the 1930s led to more bank runs.
What about adopting regulations that provide for uniform disclosure, loan-to-value ratios, rate caps, or otherwise stiffen lending standards? How can one cavil against such seemingly logical attempts to enhance disclosure and level the playing field? The problem with regulation is that it is impossible ex ante to determine whether its costs outweigh benefits. How can one abstractly agree on the right lending rate or disclosure standard? Any regulatory solution is one imposed from above by parties far removed from pricing risk on a day- to- day basis.
A regulatory solution is a one size fits all mentality that consequently stifles the free market's innovation and creativity and in the process restricts competition by raising entry costs. Friedrich Hayek, 1974 Nobel Laureate in Economics, referred to this as the "pretense of knowledge" syndrome infecting central planners. More order and fairness comes out of the spontaneous interaction of thousands of voluntary free market transactions.
We are not asserting that the market is perfect; as long as men aren't angels, perfection is not the measuring rod. However, the market at least is based on the voluntary, consensual decisions of thousands of individuals rather than on the arbitrary dictates of politicians. Mistakes ex post are surely and quickly redressed. While painful, it is normal that businesses and individuals make errors, that unsound investments are liquidated, that new covenants for lending are set by the interplay of supply and demand.
In their rush to do something, legislators ignore that the market is a dynamic, ever-adjusting process. Credit agencies are reviewing their standards, shareholders are voting with their pocketbooks, new sources of capital are trying to provide liquidity on revised terms, mortgage insurers are recalibrating premiums and required documentation, etc.
One's ardent support of the free-market process does not mean that one is an apologist for big corporations or turns a blind idea to subprime lending fraud or malfeasance. If anything, big corporations often have a far-too-cozy relationship with Washington. Grandiose pronouncements about a public/private partnership are often thinly disguised means to create regulatory barriers of entry for smaller competitors. The free-market system can only thrive if private property rights are honored and enforced. If loan contracts were entered into via force or fraud, the court system is the appropriate forum for redress and restitution.
In short, legislators at all levels should resist the urge to meddle. Doing nothing requires discipline and intellectual honesty and will hasten the recovery.