Consider a borrower who can’t meet his or her mortgage payments and is facing foreclosure. In the past, as Gretchen Morgenson recently pointed out in The Times, the bank that made the loan would often have been willing to offer a workout, modifying the loan’s terms to make it affordable, because what the borrower was able to pay would be worth more to the bank than its incurring the costs of foreclosure and trying to resell the home. That would have been especially likely in the face of a depressed housing market.I don't see the market failure, but I don't disagree with the last paragraph if that assertion is removed. We had financial innovation that lowered the upfront costs of financing real estate transactions and raised the costs in the event of default. That we are now "in the event of default" and seeing the higher transaction costs does not mean we have a market failure. That, by itself, does not warrant the government involvement.
Today, however, the mortgage broker who made the loan is usually, as Ms. Morgenson says, “the first link in a financial merry-go-round.” The mortgage was bundled with others and sold to investment banks, who in turn sliced and diced the claims to produce artificial assets that Moody’s or Standard & Poor’s were willing to classify as AAA. And the result is that there’s nobody to deal with.
This looks to me like a clear case for government intervention: there’s a serious market failure, and fixing that failure could greatly help thousands, maybe hundreds of thousands, of Americans. The federal government shouldn’t be providing bailouts, but it should be helping to arrange workouts.
However, in addition to the shift on financing arrangements, we had fraud at various points in this process, and determining the financial penalties in those instances would likely have to be worked out over years in protacted legal battles. Congress can pass legislation to substitute for those battles. I haven't seen a better idea than Dean Baker's, which I discussed in the last post.
The consequence of passing it is that it gives the borrower the upper hand in the workout negotiations--the borrower can stay and pay rent as a substitute for the mortgage, and the holder of the mortgage can hold or sell the property (without evicting the tenant) in light of that. I presume that most dispositions will be in either of two forms. Some borrowers will realize that they really cannot afford the house and find a more affordable one, without being evicted unless they also cannot pay rent. In other cases, the holder of the mortgage will sell the property back to the borrower at a discounted price, with new financing on more sensible terms from a new lender. This avoids the need for the government to get actively involved in the terms of the workouts, placing the cost of disposing the property on the lending community where it belongs.
And what of the Wall Street entities that have taken a financial beating as the bottom dropped out of this market? They get to be the roadkill on the capitalist highway, food for scavengers in the financial market. You wouldn't know it from the headlines dominating the news media today, but there are plenty of financial institutions that have been prudent and maintained their liquidity though this chaos. They are going to get some bargains in the months to come.