How Lending Decisions Produce Sub-Optimal Social Outcomes

The New York Times reports that many people who would like to refinance their mortgages into lower interest rate 30 year fixed rate mortgages are unable to do so.

Of course, were households able to refinance their mortgages, their probability of default would fall, because the present value of their mortgage balance would fall (effectively lowering the loan-to-value ratio) and payment-to-income ratios would also fall. At the same time, because the cost of capital for lenders is low, financial institutions would find the refinanced loans profitable.

But when a lender holds an underwater loan, it wants to earn as much profit as possible, and so hasn’t sufficient incentive to lower the interest rate. The judgment of these lenders is that the profit gained by continuing to charge a high interest rate is greater than the potential losses from the increased probability of default. At the same time, other lenders do not want to take out a loan that is underwater. Hence, people are stuck.

This is surely socially less than optimal–keeping foreclosures as low as possible is in everyone’s best interest at the moment. So here is a policy proposition–if a borrower has always been current on repaying their mortgage, they get to refinance at the current low rate of interest. Financial institutions are being subsidized with unnaturally low interest rates. Borrowers should get their share of those subsidies.

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About Richard K. Green 103 Articles

Affiliation: University of Southern California

Richard K. Green, Ph.D., is the Director of the USC Lusk Center for Real Estate. He holds the Lusk Chair in Real Estate and is Professor in the School of Policy, Planning, and Development and the Marshall School of Business at the University of Southern California.

Prior to joining the USC faculty, Dr. Green spent four years as the Oliver T. Carr, Jr., Chair of Real Estate Finance at The George Washington University School of Business. He was Director of the Center for Washington Area Studies and the Center for Real Estate and Urban Studies at that institution. Dr. Green also taught real estate finance and economics courses for 12 years at the University of Wisconsin-Madison, where he was Wangard Faculty Scholar and Chair of Real Estate and Urban Land Economics. He also has been principal economist and director of financial strategy and policy analysis at Freddie Mac.

His research addresses housing markets, housing policy, tax policy, transportation, mortgage finance and urban growth. He is a member of two academic journal editorial boards, and a reviewer for several others.

His work is published in a number of journals including the American Economic Review, Journal of Economic Perspectives, Journal of Real Estate Finance and Economics, Journal of Urban Economics, Land Economics, Regional Science and Urban Economics, Real Estate Economics, Housing Policy Debate, Journal of Housing Economics, and Urban Studies.

His book with Stephen Malpezzi, A Primer on U.S. Housing Markets and Housing Policy, is used at universities throughout the country. His work has been cited or he has been quoted in the New York Times, The Wall Street Journal, The Washington Post, the Christian Science Monitor, the Los Angeles Times, Newsweek and the Economist, as well as other outlets.

Dr. Green earned his Ph.D. and M.S. in economics from the University of Wisconsin-Madison. He earned his A.B. in economics from Harvard University.

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