Lenders need to feel the pain

Wednesday, December 26, 2007 10:58 PM CST

Now that the subprime crisis is clear, the blame cycle has begun. There is enough criticism of what the Federal Reserve didn’t do, should have done, and ought to do to fill several books – as it doubtless will in a few months.

While there are proposals to fix the economy now and the subprime market in the future, there isn’t much discussion of what should happen immediately to the lenders who caused the problem.

Like other economic crises, this one was long in the making. Gradually home lending shifted from banks to a loan market backed with government-guaranteed mortgages, and then to money raised with securities backed only by mortgages. That’s where greed took hold. Lenders operating with few restrictions and seeking ever higher returns used initially low interest rates and payments to lure in people with poor credit. Meanwhile, mortgage brokers earned payments based on the number of loans they created, not the solidity of those loans.

This mortgage system worked because it tapped a large pool of cash and gave homes to people who otherwise wouldn’t have them. And it’s accepted wisdom that people who have a stake in homes may translate that into taking seriously their stake in a community. That was good. What wasn’t good was the ballooning interest payments which, combined with a sagging economy, threaten to force many lower income people out of those homes.

So what should we do with these greedy subprime lenders? We could gloat as we watched them fail, but in reality that could squeeze the money supply so much that the economy would fall into recession, and that would hurt even the gloaters. Yet there has to be some punishment because otherwise the companies which overreached will keep doing the same, just as undiscriminating disaster insurance encourages people to rebuild in floodplains or areas prone to wildfires.

Among the Fed’s proposed rules to govern future subprime lenders is one which would require them to establish escrow accounts for taxes and insurance. This would be a good place to start right now.

Lenders should be required to renegotiate terms so that 80 percent of their subprime borrowers could be kept in their homes, and they should be required to have a stake in properties by helping to fund escrow accounts for taxes and insurance. Lender shareholders, who as owners must accept responsibility for their companies’ actions, should be required to keep those investments for seven years, or if that trespasses too much on private rights, then they should not be able to take a tax write-off from subprime investment losses. These arbitrary numbers may need adjusting, but they would enforce responsibility and a certain amount of pain to drive the lesson home. It’s unlikely these lenders will fail because the Fed is steadying the credit market, and it’s unlikely that shareholders would be driven into bankruptcy because their investments are probably diversified.

Free markets are good tools. They allocate resources well, but they are only tools. If allowed to operate without rules and oversight they are as subject to greed and larceny as any other human system. Our task is to make sure that the invisible hand of the marketplace slaps the people who deserve it but doesn’t swat people off the ladder of opportunity which we enticed them to climb.

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