Some 4.2 million mortgage borrowers are either seriously delinquent or have had their cases referred to lawyers to pursue foreclosure auctions, according to LPS Applied Analytics. Of those, two-thirds have made no payments at all for at least a year, and nearly one-third have gone more than two years. The obvious question is what should the government do about foreclosures?

The federal government has set aside nearly $50 billion, to help distressed homeowners facing foreclosure. Many local government programs emerged with the intent to help homeowners stay in their homes. In the media, homeowners who do make their mortgage payments are often referred to as “foreclosure victims” or as “mortgage victims”. It seems that the only right thing for the government to do then is to help the victims as much as possible.

The current government policies towards current mortgage borrowers can have far-reaching long-term consequences for the housing market. First, the cases of borrowers who can make mortgage payments, but don’t want to, became recently a widespread phenomenon. When the government treats mortgage borrowers as “victims”, this provides incentives for any mortgage borrower to stop paying (i.e. stop being victimized). Notice that people who borrow money for a house, but then stop paying their mortgage, are still called “homeowners” in the media and by government officials, despite the fact that they did not pay for their home. By classifying someone who refuses to pay for a product that he/she bought as a victim, we destroy the fundamental values of honesty and trust.

A Nobel Prize winning economist Kenneth Arrow[1], pointed that: “Virtually every commercial transaction has within itself an element of trust, certainly any transaction conducted over a period of time. It can be plausibly argued that much of the economic backwardness in the world can be explained by the lack of mutual confidence.”

A mortgage is a contract between a borrower and a lender. This contract specifies that if the borrower stops making payments on the loan, then the lender obtains possession of the collateral – the house. Government policies that treat the borrowers as victims are essentially legitimize breaking of the mortgage contracts by the borrowers. Now suppose that you are not a home owner, but might become one in the future. Knowing that mortgage contracts are poorly enforced, banks will be reluctant to give you a loan in the future. Renters, such as the writer of this commentary, not only subsidize the current homeowners, but also make it harder for themselves to ever become homeowners in the future.

Having said that, the argument presented above ignores many cases where banks and government are themselves guilty in creating mortgage defaults. In many cases, the banker did not explain properly the potential risks in adjustable rate mortgages to the client. This can happen for example due to lack of professionalism on behalf of the banker. The natural question in these cases is who should be responsible for mutual understanding of the mortgage contract? The answer to this question is far from obvious.

In many other cases, neither the bank (lender) nor the borrower is guilty for failed contract. In fact, the existence of government sponsored enterprises (GSE), Fannie Mae and Freddie Mac, reduced the banks’ incentives to screen borrowers. Virtually every mortgage at the onset of the mortgage crisis had to receive a stamp of approval from Fannie and Freddie. These approvals were given in a very liberal fashion, and the standards for approval were very low. Virtually everyone who applied for a mortgage – got one. In economics, such arrangement between the banks and GSEs is called “implicit insurance”. Banks did not need to worry about giving bad loans because Fannie and Freddie were authorizing the loans, and buying most of the mortgages. Given this massive involvement of the government in the mortgage markets, can the government not do anything about foreclosures?

In summary, not all foreclosures are the same. In some cases customers gambled on the future values of their home, and lost the gamble. In other cases, borrowers were misled by incompetent bankers. And at last, there is a third group that was misled by the government. How to separate the different cases, and what is the optimal policy now, remains an open question. One clear lesson from the recent crisis is that consumers, who consider buying a house, must learn the basics of mortgages. People should not sign a mortgage contract, which commits them to payments of hundreds of thousands of dollars, without understanding what they are signing.