Are Moratoria Ever Needed? Can the market do its own workouts?

The following post is a response to BCG81 who commented on this post:

The distinction between temporary and permanent income shocks ought to lead a workout guy to give you restructurings where that is the higher-NPV alternative [relative to foreclosure]. 

First, to be clear, I do not believe foreclosure moratoria are the best policy instrument at the moment.  I continue to believe my foreclosure plan (see it here) is the best permanently workable plan.  Note, in particular, that it has the benefit of not needing a temporary versus permanent distinction and induces no forward-looking market distortions.

But, to your point and thinking solely about moratoria, I agree.  Banks are good (not perfect but good) at taking actions that are best for them.  If/when banks find it in their interest to do wide scale workouts, they will do so.  But with foreclosures there is likely an important macroeconomic externality.  A foreclosure depresses local property values (see my post here), increasing the probability of further foreclosures, and potentially devastating neighborhoods.  .  The bank, correctly, does not take this fully into account.  Accordingly, it may be socially optimal to prevent foreclosures even when workouts yield lower bank profits. 

In addition, in depressed neighborhoods, banks should rush to foreclose.  The sooner they take possession and dump the property the higher their profits are likely to be.  It’s a poor equilibrium but each bank should follow this strategy.  And, the most efficient foreclosure bank will indeed likely perform the best.  This rush to foreclosure may speed adjustment where it is needed but may also put neighborhoods, which would have been only temporarily impaired, over the brink. 

I am not saying banks can’t do the workouts.  I am only saying the policy and banking motivations are not aligned. 

One problem is the lending that drove house prices and pretty much the rest of the economy through 2007, income just didn't matter.  Nobody paid any attention to whether the borrower had enough income to repay. So a big—maybe the biggest—part of the problem is probably automatically equivalent to a permanent shock.

In early 2007, we could have argued over your motivating fact.  Poor lending standards might have been the culprit.  I think, though, that with the acute perception of hindsight the evidence now leans in favor of an income shock not poor lending standards.  Be that as it may, your point stands.  Many households borrowed more than they could afford with their realized income.  And these households are likely the biggest part of the current problem.  Blanket moratoria are likely preventing adjustment in these dimensions. 

Also, don’t moratoria in response to temporary shocks also keep the market from adjusting "in a good way"? Couldn't this build inventory, potentially increasing supply relative to demand and causing prices to fall during the time it takes to resolve the temporary shock. And depending on how you restructure the loan during this period (e.g., is interest paid? capitalized?), it may offer lenders a lower recovery than foreclosure, thus impeding the deleveraging process.

Too true.  Moratoria, even temporary ones, distort markets.  Without short-term price adjustment, supply may increase, pushing house prices down once the moratoria is lifted.  But the moratoria, assuming the shock was correctly identified, do not impede the deleveraging process.  Households who face a temporary shock do not need to deleverage; they may want to delever but by definition they can afford their current debt level. 

The model seems to be the LDC debt crisis of the 1980s. Personally I think this overstates the importance of the banking system (beyond its ability to clear payments and provide working capital) in an environment like this and over prioritizes it in recovery policy/strategy.

Touché.  The LDC crisis resolution is exactly the moratoria model.  Those economies suffered temporary shocks and moratoria allowed them to repay most of their debt.  And, in the process, turned them into permanently indebted, serial defaulters. 

Defeated, I can only repeat my first point.  I do not believe foreclosure moratoria are the best policy tool available.  I like my plan—still feel free to have at it if you are so inclined.