Friday, February 08, 2008

WSJ: "Mail in the Keys"

This WSJ piece provides a good analysis of how the mortgage market will self-correct if left alone. It's well worth reading in its entirety, but here's a taste:
In most cases, once a homebuyer splits, the mortgage-securities investors are stuck with the loss. In some states, including California and Arizona, this provision is the letter of the law. In others, the bank forgives the balance of the loan -- a common practice that's unlikely to change now, given the criminal and civil investigations banks are already sweating through.

Essentially, mortgage-bond investors, seemingly unwittingly, sold homebuyers a put option, without properly pricing it, and now homeowners are exercising that option. Moreover, prime borrowers in many markets face the same incentives.

Yes, this behavior is new -- but only when it comes to houses. Americans have long been able to cut their losses from bad investments and start over. It stands to reason that when the market made houses into yet another speculative investment, Americans would do the same.

Borrowers acted rationally in response to market forces and incentives during the bubble: Buy a house because prices always go up; you can't lose. Many are acting rationally now: Mail the keys back and un-borrow the money, because prices are sinking fast while the debt isn't. When the house was purchased not as a first home but as a rental investment, the decision is even easier.

Imagine: Politicians keep saying that Americans need protection from their big, bad lenders -- but that protection is already there.
The article doesn't purport to analyze how we got into this situation, and I'm not capable of doing so either, but in general, for those who would argue that the market caused the problems so shouldn't be relied on to fix them, I'd note that while I don't think that markets are perfect, i.e. the perfect competition and rational expectations models seem to imply that markets will always and instantaneously price in all known information, I do think that much of the current malaise in the credit market comes from market interference, most notably the Fed's long-standing easy money policies -- not from a general market failure.

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