Although the federal government still seems not to understand the concept of economic moral hazard, it seems a few state attorneys general do. Let’s hope they prevail as other attorneys general and government regulators pressure the nation’s largest home mortgage lenders on mortgage servicing and foreclosure practices.
Some attorneys general and regulators reportedly want to force lenders to, among other things, cut the amounts owed by some borrowers facing foreclosure.
Almost no information came out of a recent meeting at the Justice Department in Washington, DC among regulators, attorneys general, and officials of the nation’s largest home mortgage lenders. The financial institutions represented included Bank of America Corp., J.P. Morgan Chase & Co., Wells Fargo & Co., Citigroup Inc., and Ally Financial Inc.’s GMAC.
These are the largest home loan firms in the nation, among the “too-big-to-fail” firms that have taxpayer protections unavailable to smaller firms in the industry. That guarantee gives these firms—which contributed so mightily to the housing collapse and financial crisis in the first place—competitive advantages over their smaller and often more responsibly run competitors.
Though no one is giving out details about what was said at the meeting, we do know that several weeks ago a 27-page “term sheet” went to these mortgage servicers. The proposal would force procedural changes on servicers, including a ban on foreclosure proceedings while a loan modification is pending.
To their credit, at least seven state attorneys general have publicly opposed mandating mortgage holders reduce principal owed by lenders. These attorneys general, including Greg Abbott of Texas, Pam Bondi of Florida, and Scott Pruitt of Oklahoma, rightly fear reductions in the amount of principal owed could encourage homeowners who are paying their mortgages to stop making payments in order to go into default and become eligible to receive a mortgage writedown.
In other words, these attorneys general recognize the risk of moral hazard, the idea that some government policies make certain bad decisions or reckless conduct more likely.
Moral hazard played a huge role in the housing collapse and financial crisis. Fannie Mae and Freddie Mac, the now infamous “government-sponsored entities” that made much of the wheeling and dealing in bad mortgages possible, succumbed to moral hazard because of the implicit government guarantees they had. Those guarantees became explicit when the government shoveled billions of dollars into them to keep them from collapsing as a result of the real estate bust they helped cause.
Similarly, if a banker knows his bank will be rescued no matter how much money it loses or how badly it abuses its customers, he’s inclined to play faster and looser with money and banking regulations than he otherwise would.
Through its bailouts and designations of firms as too big to fail, the federal government has put more risk, rather than less, into the financial system. The right response to the financial crisis would have been to let insolvent firms collapse. Doubling down on moral hazard by forcing banks to write down mortgages now would just make a bad situation worse.
Until the financial panic in 2008, people who could not pay their mortgages were expected to sell their houses or lose them through foreclosure. And banks that loaned money to too many people who could not repay their mortgages were expected to go out of business. But with the bank bailouts and mortgage rescue schemes that government has thrust on us to protect businesses and individuals who got themselves into financial trouble, those incentives to act prudently or suffer the consequences have been weakened.
Protecting recklessness and irresponsibility by reducing the debt owed by people who go into default on their mortgages would beget more recklessness and irresponsibility.
Let’s hope more of our state attorneys general come to realize this.
Steve Stanek ([email protected]) is a research fellow at The Heartland Institute in Chicago.