Tuesday, December 18, 2007

While the Fed Slept?

The Times this morning gives a brief history of the interaction between regulatory agencies (particularly the Fed) and subprime mortgages:


The story points out, correctly, the among the few to see the problem coming were Ned Gramlich and current FDIC Chair Sheila Bair. Their foresight was remarkable, and many of the ideas they had for avoiding the crisis--including closer scrutiny of lending practices--were sensible.

But one thing that bothers me is the idea that the way to prevent a future crisis is the imposition of an "ability-to-pay" standard. Consider the case of the 35 year old who had had a strong income and decides to drop out of the workforce for two years to get an MBA. She moves to Palo Alto to do so. Her income is close to zero for two years, but she wants to buy a condo instead of renting. Is this person really a default risk? Or consider the case of a family confronted with a large medical bill--they decide to take out a home equity loan that pushes up their payment to income ratio to 55 percent for a few years. Is this a worse outcome than having it see its credit record deteriorate because it can't pay its medical bills?

It is possible that these instances are sufficiently rare that putting in place an ability-to-pay standard would be welfare improving. But I would do at it a different way. If everyone involved in the lending chain has money to protect, they will have an incentive to avoid making loans that can't possibly perform. And that, in the end, is the point.

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