David R. Henderson  

Yeah, right . . . The Time Inconsistency Problem

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Yesterday, Shaun Donovan, the secretary of the Department of Housing and Urban Development, was on Face the Nation to defend President Obama's bailout program for mortgage holders. The questioner, CBS's Bob Schieffer, asked some good questions.

One of his best questions (at the 6:40 point):

Isn't that [letting bankruptcy judges rewrite mortgage loans] going to discourage lenders from making new loans?

Donovan sidestepped the issue to make a point about fairness. He pointed out that if you have a second home, you can get the terms modified in bankruptcy, but not if you have one home. It's only fair, he said, to let owners of one home have the same option. But this ignores the point that lenders, if they wanted to know, knew this difference in rules in advance and that now, if the legislation is passed, the rules will be changed after the fact. Donovan did, though, circle back and answer the question. Here's his answer:

We also have to do it right to make sure that we don't hurt the mortgage market. What we've proposed, and we're working with Congress on, is a modification of loans in existence now, the ones that have caused all the trouble [those pesky loans--I thought it was people who caused trouble]. We're not talking about applying this to loans going forward. We think doing that means that it's not going to affect, in any significant way, mortgages in the future, that it won't hurt the mortgage market in the future.

How naive does Donovan think lenders are? Are they really going to say to themselves:

I'll be just as willing to lend in the future as I otherwise would have been because I have absolute confidence that a government that gives judges the power to rewrite mortgages after the fact is never going to try to use that power on future mortgages.

Economists' fancy term for what I call the Lucy/Charlie Brown football problem (where Lucy promises yet again not to pull back the football before Charlie Brown tries to kick it) is the "time inconsistency problem."

An interesting instance of governments "pulling back the football" is the New York city rent controllers. In his article, "Rent Control," Walter Block writes:

Although many rent-control ordinances specifically exempt new rental units from coverage, investors are too cautious (perhaps too smart) to put their faith in rental housing. In numerous cases housing units supposedly exempt forever from controls were nevertheless brought under the provisions of this law due to some "emergency" or other. New York City's government, for example, has three times broken its promise to exempt new or vacant units from control. So prevalent is this practice of rent-control authorities that a new term has been invented to describe it: "recapture."

Schieffer's worst moment was his last:

Mr. Secretary, I want to wish you the very best. I think everyone hopes that you'll succeed on this.

I don't. I hope the legislation fails. And the reason has to do, not just with ethics, and not just that propping up housing prices hurts potential buyers on the sidelines, but also with the "time inconsistency problem."


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COMMENTS (8 to date)
The Student writes:

So if we want to allocate away from the housing sector, is it a bad thing the government is reducing the incentives to invest in that sector?

hacs writes:

Maybe the problem is discretion instead of rules.

RickC writes:

The Student,

"So if we want to allocate away from the housing sector . . ."

Who is "we"? No one asked me for input on this bailout. I believe the "we", if you're talking about central planners, are the ones who got us into this mess in the first place. The market will re-allocate those resources away from the housing sector in its own good time. That's how it works.

The governmental planners are only going to gum up the works. What they are attempting to do is hold prices at bubble levels. If they have their way the resources will remain misallocated until another, probably more devastating crash, comes along; and it will.

If one of the unintended consequences of their meddling is a dis-incentivising in the housing sector we'll still have to deal with the $270 billion debt which will have been wasted money, the damages done to contract law David outlines above and many other hazards no one has yet foreseen.

hacs,

If we've moved into a rule of personal discretion instead a rule of laws we do have major problems.

MHodak writes:

"Our firm is facing a tough year, so the payroll that we promised you, well, we need to keep it this month. It will really help our bottom line, and place our business on a firmer footing. But going forward, we'll pay you just as we always promised. We won't withhold your pay again."

"Yes according to the rules, we can't score unless the ball goes over the line. But just this time, we'll count the ball being within a foot of the line as a score. It will really help our team out a lot. But this is a one-time only suspension of the ball-over-the-line rule. We promise to stick to the rule from now on."

I mean, aside from the time inconsistency problem, Donovan (or the Dems, generally) doesn't see any moral problem with any of this?

Dan Weber writes:

If the bank has a $500,000 mortgage on my $200,000 house, even though a piece of paper they have says that it's secured, only the first $200,000 is really secured.

The only thing saving the bank from taking a write-down on their loan is the fact that I don't want to go through the hassle of moving and foreclosure and the credit-ding. (And some of those don't apply at all in non-recourse states.) If I'm $3,000 underwater, I probably won't bother. If I were $300,000 underwater, I would be very very sorely tempted, and snarky comments on the Internet probably wouldn't stop me.

Now apply some Coasian economics. The bank doesn't want me to give them the shaft when it is in my economic interests to do so? Then they should offer me a better deal. Say, write down my mortgage to $200,000 in exchange for some other consideration, such as attaching a lien on the house.

KnowNothing writes:

A bit of tail chasing but ...

Perhaps inconsistency started when the BK laws were modified before 2000. Here we had the removal of 'cram down' in BK of a primary home loan.

I suppose the difference between a cram down and default/foreclosure is in who are the agents? Can a BK judge cram down more than the assessed value of the home? Is the assessor to be suspect?

The risk of a cram down I believe means the lender no longer enjoys a quasi 'senior' debt position. Perhaps this is good? It might lead to better due dilligence of the lender?

There is the law - but there is also it's 'spirit' and or intention. A slippery slope agreed.


KnowNothing writes:

http://www.calculatedriskblog.com/2007/10/just-say-yes-to-cram-downs.html

My comments relate to the above blog.

Charlie writes:

There is a countervailing interest that at least should be considered. In the old days, when banks held mortgages, it was common for the banks to renogotiate in an attempt to prevent foreclosure. With mortgages chopped up into little pieces and sold, the traditional counterparty is gone. I suppose the bank that still manages the loan could, but their incentives are hardly aligned correctly.

Also, time inconsistency arguments are quite sensitive to beliefs about beliefs. That is, do we believe that lenders future beliefs will be much different if the bill is not passed? They already conceive that in some certain circumstances such a measure could be passed. So how much does one data point change their opinion about the underlying distribution? If they know little about the political process that creates bankruptcy law, the data point could mean a lot. But given the number of lobby groups and the constant rewriting of bankruptcy laws, it seems lenders probably already have lots of information about the policy environment going forward, and I doubt this specific legislation would change those beliefs much.

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