Laura Rowley Money & Happiness

In the past, when government has attempted to address a complex set of issues with relatively straightforward regulation, it has often unleashed the law of unintended consequences. In short, weird things happen when you give people rules or incentives in an effort to change their behavior, because they will almost always try to game the system -- or, in finance-speak, fall prey to moral hazard.

Unintended Consequences

In a Freakonomics column earlier this year in the New York Times, Stephen Dubner and Steven Levitt offered a few potent examples. One study that examined the effect of the Endangered Species Act found that property owners who suspected their land might attract protected species rushed to clear-cut the trees (despite low timber prices) to avoid losing their investments.

Another study found that employment of disabled people actually fell after the Americans with Disabilities Act was adopted, because employers -- afraid they wouldn't be able to discipline or dismiss an incompetent worker who happened to be disabled -- stopped hiring them altogether. This isn't to say these weren't worthy laws, only that they can engender unintended results.

Let's consider how the law of unintended consequences might work in the plan that the Federal Deposit Insurance Corporation (FDIC) is implementing with mortgages it acquired when it took over IndyMac bank in California.

The Best-Laid Plans

Here's how the plan works: A homeowner who lives in a house and misses at least three loan payments can qualify for a streamlined workout designed to reduce the monthly payment to a 38 percent debt-to-income ratio. (Principal, interest, taxes, and insurance would be no more than 38 percent of gross income.) The plan initially targets 40,000 mortgages.

To make that happen, the FDIC is extending the term of the loan to 40 years; lowering the interest rate permanently; lowering the interest rate as low as 3 percent for up to 5 years; or excluding part of the loan balance when calculating the monthly payment. (In the latter instance, the amount owed would not change and the borrower would have to pay it back when he sells or refinances.) The workout can also include some combination of the above.

Here's how the law of unintended consequences could work in this scenario:

1. The struggling homeowner who scrimps and saves to make the mortgage payment stops paying for three months in order to qualify for a workout.

2. The borrower reduces his household income; if unemployed, he stops looking for work or takes a low-paying job temporarily (barista at Starbucks, for example). A two-income family would have one of the wage-earners quit and stay home with the kids. Once the mortgage has been adjusted based on the lower income and set for five years, the borrowers seek new jobs (or second incomes), ideally with higher wages.

Contemplating an Alternative

In an interview on CNN, FDIC Chairwoman Sheila Bair said she would like to expand the plan throughout the industry at a cost of $24 billion to taxpayers. Last month, the FDIC outlined the program's details to encourage banks to adopt it.

Here's an alternative plan, suggested by reader Warren Holmes in a recent email (and embellished a bit here). It would avoid the law of unintended consequences and the moral hazard dilemma -- and encourage responsible borrowing in the future:

Take the $24 billion and create a "Refinance America Program" (RAP) that gives homeowners the opportunity to refinance into new 30-year mortgages at 3 to 4 percent. But offer it to people who put at least 10 percent down when they purchased their homes, have never missed a mortgage payment over a five-year period, and are current in their loans.

A homeowner would only be allowed to participate in the program once, but the RAP plan would become available every ten years.

RAP Sheet

Let's look at the possible consequences of the RAP, both intended and unintended:

1. Every intelligent borrower who fits the profile will immediately refinance to the bargain rate.

2. The responsible homeowners who refinance would enjoy lower monthly payments, freeing up money to spend and helping to prop up the economy in the short term. (Refinancing a 30-year, fixed-rate maximum conforming loan -- $417,000 -- from 6 percent to 3 percent would decrease the monthly payment by about $740.)

3. If a homeowner decides to put their extra cash into the bank instead of spending it, that would provide banks with more funds to lend and help thaw the credit freeze. It would also give lenders more capital to work out all the subprime loans they shouldn't have made in the first place (without using taxpayer funds). And boosting the savings rate in the United States would reduce the risk that foreign countries holding U.S. government debt will decide to wield it as an economic or political club in the future.

4. The government could presumably sell new mortgage-backed securities based on these loans, because every borrower has already been proven creditworthy (and 4 percent is a pretty decent return these days).

5. Investors and institutions that hold the top classes of current mortgage-backed securities would be paid off early, and could reinvest in the new securities. Those who invested in the toxic waste would be left with, well, toxic waste. But presumably it would be easier for banks to identify who's holding the toxic waste, quarantine them, and begin lending again to solvent institutions (see last week's column on the "information problem").

6. New homebuyers would be given a juicy incentive to save up a 10 percent down payment and avoid defaulting on their loans.

Rewarding the Responsible

The plan might also be offered to homeowners (for example, elderly borrowers) who were tricked into refinancing into a subprime loan in the last three years by fraudulent mortgage brokers. The borrowers would simply be required to demonstrate consistent payments over five years in the mortgage they held prior to the refinance for a specified period.

If it's somehow morally objectionable to offer RAP to the super-wealthy, limit the plan to borrowers in a specific income range ($250,000 seems to be the popular dividing line these days).

I have no doubt that readers will find more than a few unintended consequences in this modest proposal. But I'm sick to death of bailouts. Why not reward the responsible?