Academic

The Subprime Mess-- Skeel

By David Skeel and Bill Stuntz

As Obama, Clinton, and everyone else tout their remedies for the subprime crisis, I?m reminded of the old joke about a group of blind men who encounter an elephant. The man who grabs the elephant?s leg tells the others he has encountered a tree, the one who touches the trunk is sure it?s a huge snake, and so on. In the fall, subprime worries centered on the losses that banks were suffering, and the possibility that credit markets would seize up. Now the homeowners who are facing default are on center stage.

These parts are connected in ways that often get obscured.

Mortgage lenders lent money to the homeowners who are now facing default. The mortgages were immediately sold, often to an investment bank. The money for purchasing the mortgages came from investors (many of them banks), who put up cash in return for (?mortgage-backed?) securities linked to the special purpose entity that was set up to hold the mortgages. Here?s the problem with this market in mortgages: a lender who immediately resells the mortgage to someone else has very little incentive to carefully screen its borrowers. And they didn?t. A new study by several economists shows that mortgages that were securitized were 20% more likely to default later. The first test of any response to the subprime crisis should be whether it both encourages lenders to be more careful, and helps homeowners who might otherwise lose their homes.

Barrack Obama has proposed a tax credit to homeowners for 10% of their mortgage interest and $10 billion in bonds to help borrowers avoid foreclosure. This amounts to a small scale bailout. The problem with a bailout is that it provides no discipline for the lenders who shouldn?t have been making many of these loans.

Hillary Clinton calls for a 90-day moratorium on foreclosures and a five-year freeze on adjustable mortgages. This approach is more promising but still flawed. In the nineteenth century and during the Depression, moratoria were often used (even though they were unconstitutional in the nineteenth century, and everyone knew it) to help people keep their homes in a depression. Often this was the best tool lawmakers had at their disposal (the federal government wasn?t in the bailout business in those days), and it does help borrowers without letting lenders off the hook for their profligacy. But the moratorium is largely unnecessary given the current market chill; the interest rate freeze is blunt and arbitrary; and most importantly, neither would do anything to discourage the next round of overzealous lending and borrowing.

The most promising proposal, in my view, is a small change to the bankruptcy laws proposed by Senator Durbin. The Durbin proposal, which the Bush administration unfortunately is threatening to veto, would let a borrower who files for bankruptcy reduce her mortgage to the value of the property if the property is now worth less than the mortgage. (Under current law, mortgages are sacrosanct, a tribute to the influence of the financial services industry). Not only would this discipline lenders who made unwarranted loans; it also would provide an individualized solution to a homeowner?s financial crisis. And many troubled borrowers would never need to file for bankruptcy to get appropriate relief. The prospect of bankruptcy would encourage lenders to restructure these loans outside of bankruptcy, thus saving everyone the cost of bankruptcy. Both Obama and Clinton appear to support the bankruptcy change, but they don?t talk about it much these days, perhaps because technical bankruptcy reform doesn?t make for great sound bites.

As I will argue in more detail in another post, I believe that the bankruptcy approach should be attractive to my fellow evangelicals, despite many evangelicals? discomfort with generous bankruptcy laws. Although traditional usury regulation is justly unpopular, the importance of fair lending? of a fair price and concern for the borrower?s wellbeing? is a pervasive theme in the Bible. (Exodus 22:26, for instance, instructs a lender who has taken a borrower?s coat in pledge to give it back by sunset). I have quibbles with some of the details of the Durbin proposal, and I share many evangelicals? concern that borrowers be encouraged to repay what they owe if they can, but the Durbin proposal sure looks like the best of the current options.

Full post as published by Less than the Least on February 28, 2008 (boomark / email).