Monday, November 26, 2007

Brad Delong cites the FT on The Arnold and Subprime

By bringing together four large subprime lenders and getting them to cooperate, Schwarzenegger has done something incredibly important--he has gotten lenders out of the prisoner's dillemma and onto a welfare-improving cooperative equilibrium.

Unless everyone agrees to modify their loans, everyone has an incentive not to modify (if there are going to be lots of defaults,one might as well get a high coupon rate for each mortgage that stays current). But now all the players have an incentive to modity, so long as everyone else modifies. This will prevent some defaults, and thus reduce the inventory of houses for sale relative to what it might have been.

But if any one of the four lenders starts fooling around, the whole thing will come unglued. It is important that the Terminator use his ability to intimidate to keep the deal together.

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