Why Foreclosure Prevention is Not Helpful

(1) Loan modifications redistribute wealth

This is a feature, not a bug, so long as wealth is redistributed from the politically unfavored to the politically favored.

(2) Loan modifications do not eliminate deadweight loss.

...but they do create jobs, jobs, jobs between now and the next election.

(3) Many borrowers are not eligible for loan modifications.

Who cares? As long as politicians look like they're doing something for the "middle class" and can buypick up a few votes, it's all good.

(4) Loan modifications often go bad.

All that means is we need another government program to cover those whose mortgage modifications failed. Not only will it keep people in their homes, but it will provide jobs, jobs, jobs for politically-connected liberal arts graduates, who will in turn provide a reliable voting base for future expansions of government power. Priorities, Arnold, priorities!

"1. Loan modifications do not create wealth.
A loan modification redistributes wealth The borrower gains and the lender loses. To the extent that home prices are higher than they would otherwise be, current home owners gain and potential home owners lose."

A loan doesn't create or destroy wealth in static time. But across time it certainly can do either. In the same sense, there is potential for a loan modification to create or destroy wealth over time. When demand in aggregate is depressed, capital being allocated toward people and businesses that will consume more and sooner there may create a net increase in wealth and GDP over time.

"2. Loan modifications do not eliminate deadweight loss.
Yes, foreclosures involve deadweight loss-the cost of moving and so on. But loan modifications also involve deadweight loss. It costs servicers a lot of money to train workers to implement loan modifications according to whatever rules are set up."

Certainly there is potential for economies of scale for loan servicers that can minimize the deadweight losses from loan modifications that does not exist for foreclosed homeowners. The deadweight losses are potentially less under loan modifications.

Foreclosure prevention is certainly not universally good, but neither is it universally bad, as you are implying. It seems that the way it has been employed over the past 4 years has been bad. But not because it must always be bad.

Erice Morey: "Foreclosure prevention is certainly not universally good, but neither is it universally bad, as you are implying. It seems that the way it has been employed over the past 4 years has been bad. But not because it must always be bad."

I don't think Dr. Kling was implying that it was universally bad, rather that the Fed should just let normal market forces play out. Let the banks and their customers resolve what's in each's best interest. That will often result in loan modifications, just slightly fewer of them - if the government insists on putting its finger on the scale on the loan modification side.

Note how it always comes down to, "We can't trust the market to do the best thing on its own. We smart government types need to jump in and give it an assist." If government types ever admitted they were wrong in a timely manner - say like Barney Frank and his support of Fannie and Freddie - I'd be more amenable to their claims of superior understanding of the general welfare of some given market.

The winner in loan mods would be the lender (assuming his intent was honest) not the borrower. The borrower pretty much breaks even at best. Now, in the long term, the lender will likely pay but the lender says "the king may die or the horse may yet learn to sing but at least I've gotten myself a few more years before I've got to pay the piper".

""We can't trust the market to do the best thing on its own."

Clearly, there are times when the market fails to deliver the greatest of possible outcomes. Clearly, there have been Government interventions and regulations that have helped create better outcomes as well as worse. The debate is valid; to dismiss out of hand the potential of any and all government interaction with markets would be foolish.

"I don't think Dr. Kling was implying that it was universally bad, rather that the Fed should just let normal market forces play out. Let the banks and their customers resolve what's in each's best interest."

This discounts any potential effects external to the individual transactions between the banks and their customers. Dr. Kling recognizes in his post that more than just the signatories are effected in a mortgage agreement. It is one of his objections to more loan modification for foreclosure prevention.

The point about potential homeowners is weak. If policy raises the market clearing price that means growth happened. That means everyone is better off.

If the market clearing price remains below today's price, but today's price goes up, that means the correction has just been delayed. Which is perhaps your point.

The problem with modifications is they target distressed/soon-to-be-insolvent borrowers. What needs to happen is refi of bubble debt that is likely to be paid off to free up income for other spending and investment.