Misaligned Incentives in the Housing Market

For one of my classes this semester, I have to write a blog post by 5pm each Sunday on the readings for class. Unfortunately, the blog is private so I can’t just link over to it, but I think my last post is worth re-posting here (my first two posts weren’t as insightful). As I wrote the post, I discovered how truly messed up our system is. In a way, everyone has an incentive to create a bubble in the housing market – until it pops of course. It’s a massive tragedy of the commons. Everyone does what is best for themselves and everyone is hurt in the end. It’s a big reason why we need regulators who’s livelihoods are unrelated to housing market and thus can provide neutral, effective oversight to prevent such a bubble. It’s certainly a very difficult problem and one that we haven’t solved yet.

Here’s the full post:

This week’s articles focused on the sub-prime mortgage crisis and the rampant fraud throughout the mortgage lending industry. For me, this is the most infuriating aspect of the entire crisis – everyone is to blame from lenders to borrowers to the government.

As Binyamin Appelbaum, Lisa Hammersly Munn and Ted Mellnik document in their series “Sold a Nightmare,” and Michael Hudson reveals in his piece on Countrywide Financial Corp., mortgage lenders participated in a number of fraudulent and unethical activities that eventually lead to a huge rise in foreclosures. Borrowers themselves were not blameless either. Many took on loans they knew they could not afford.

However, one aspect of the sub-prime mortgage crisis that has been overlooked is the government’s involvement in it. Here is where we find an incredible number of poorly aligned incentives that significantly contributed to the crisis.

Let’s look at incentives from a general level: Politicians want to be reelected and to attain higher office, and they do so by pleasing their constituencies. What’s one way for them to please their constituencies? Make houses more affordable and available. In fact, this may be the single best way for politicians to make their constituents happy. After all, one of the most crucial aspects of the American Dream is homeownership. Politicians have a huge incentive to promote homeownership.

And across the country, we saw lower less government oversight and a rise in government-insured loans. This, in itself, is not necessarily a bad thing. The problem is once again with incentives. Government-insured loans incentivize lenders to create loans as quick as they can, ignoring borrowers’ income, credit and ability to repay their loans. When the government insures loans, lenders have no default risk on those loans.

Now, certainly, the government was not promoting fraud here. If the program had been successful, more low-income individuals would have received loans, some of whom would have defaulted. The government would have eaten the cost of those defaults but this was the acceptable tradeoff of increased homeownership amongst low-income individuals. Continue reading “Misaligned Incentives in the Housing Market”