One Aspect of the Financial Crisis

I've attached a great article below that shows just one aspect of the government meddling that caused the current financial crisis. In a nutshell, when someone can't pay their mortgage, the bank forecloses on the house - this prevents the bank from losing all their money and allows the person living in the house to move on to a place to live that they can afford. Not much is lost by the home owner, especially these days, because not much was put down. Essentially, they paid "rent" while they lived there - in the form of their mortgage to the bank and the small amount of money they put down.

When government; however, prevents the bank from quickly foreclosing on the house and instead wants to protect the "innocent" homeowner (who isn't paying his bills), the bank cannot put the house back onto the market and recoup its losses. This keeps the banks money tied up in houses that it can't unload.

This government policy causes two things to happen:

1. Banks can no longer afford to lend - that is why we have a "credit crisis". If banks can't secure the loan with the value of the home, they have greatly increased risk in making the loan. (Unless it is government backed, which fanny and freddy provided, which is why there was "irresponsible" lending.)
   
2. People have no incentive to pay their mortgage. If they get to keep the house when they decide not to pay, there is no reason (other than character and integrity) to pay their mortgage. Sure, many will pay in this scenerio, but many will not. Hence, irresponsible borrowers ride on the efforts of the responsible borrowers.
   

Halting foreclosures is bad economic policy and one important aspect of this crisis. We must get the government out of this industry! These bad policies distort the market in ways that encourage people to make irresponsible choices. Check out the following article.

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The Libertarian: Greed, Or Incentives?

Richard Epstein 09.23.08, 12:01 AM ET

It had been my devout wish to write a set of disinterested columns about labor markets to illustrate the power of the presumption against state regulation of voluntary agreements. But the financial meltdown of the past week has rudely interrupted my plan to pillory the minimum wage.

Instead, I shall turn on a dime to address two connected questions: How did we get to that sorry state where great institutions topple, and what should be done?

On both questions, our bipartisan consensus is holding true to form. In a system that is chock-full of heavy regulation, they instantly blame the current collapse on the excesses of the free market, for which a still heavier dose of regulation supplies some supposed cure. That indictment contains few particulars. It typically rests on a populist broadside whose centerpiece is greed on Wall Street, but never on Main Street--where there are more voters.

This prior is all wrong. Greed is a constant of human nature. Financial meltdowns are not a constant of economic political life. It takes, therefore, an understanding of the overall incentive structure to explain why selfish economic behavior produces great progress on some occasions and financial ruination on others.

On this question, your stalwart libertarian is persona non grata in respectable company. If voluntary markets normally align private incentives with social welfare, then always look first for a government intervention that knocks those incentives off line. It’s not hard to find some culprits.

One bad move has government legislators and courts intervening to slow down mortgage foreclosures because it is socially unacceptable for people to lose their homes. Unpleasant yes, but unacceptable no. Start with this assumption: Individual tenants can be evicted at the termination of their lease. Only the ardent defenders of rent control (which has ruined New York City real estate markets) find this outcome is unacceptable. Everyone else rolls with the punches.

So what is the difference between the evicted tenant and the foreclosed owner? Only this: The owner has put a down payment on the house. But so what? Foreclosed homeowners typically made only small down payments, or even none at all. Treat their mortgage payments as lease payments, and bump up their amount a bit by dividing the down payment over the number of months before foreclosure. Not much of a financial difference between the tenant and the owner.

Yet once regulators slow down foreclosures, other potential homeowners are denied opportunities to purchase housing they can afford. The housing stock cannot recirculate. Banks that acquired this mortgage paper see their portfolios nosedive. That dicey paper, as William Isaac noted in last week’s Wall Street Journal, drives the entire economy over the edge by strict government regulations that require all financial institutions to “mark-to-market” the various instruments in their portfolio.

Unfortunately, there is no working market to mark this paper down to. To meet their bond covenants and their capital requirements, these firms have to sell their paper at distress prices that don’t reflect the upbeat fact that the anticipated income streams from this paper might well keep the firm afloat.

One bad regulatory turn leads to another, and lo, the bailouts come thick and fast. At the nth hour, wise heads often rightly conclude that some desperate measure has to be taken to prevent the financial disintegration brought on by, well, prior government regulation. Those bailouts, of course, come from the hides of taxpayers who borrowed prudently. The entire system subsidizes destructive behavior, which means that we will get more destructive behavior in the future. We might as well sell flood insurance at bargain prices in Galveston, Texas, and New Orleans.

The moral of this story is that bad regulation metastasizes. Short term heroics are no substitute for dispassionate deregulation, which won’t happen so long as our political leaders are fixated on greed. Taking steps to prevent financial meltdowns is more likely to hasten their unwelcome arrival, so says the libertarian.

Richard Epstein writes a weekly column for Forbes.com. He is a senior fellow at Stanford's Hoover Institution and a professor of law at the University of Chicago.