Should mortgage lenders bear the brunt of subprime pain?

Via Mark Thoma, the frighteningly thorough dragnet of the econoblogosphere, I found an excellent short piece by Richard Green on "cram-downs", the solution to the subprime crisis favored by Ben Bernanke, and a number of left-leaning commentators. "Make the lenders eat the damage done by their loans" is a philosophy that is not without its appeal--which is why Hillary Clinton has been flogging her five-year rate freeze on the campaign trail. But the Law of Unintended Consequences dictates that things usually aren't so easy, as Mr. Green points out:

But two serious problems stand out. First, future investors could respond by requiring higher spreads for mortgages. If these spreads get capitalized into values, the borrowers whose loans got crammed down could find themselves under water again, and the problem will remain.

Second, there is an issue of fairness. Consider two borrowers, one of whom has a 20 percent down payment, and the second of whom has a 5 percent down payment. If house prices decline by 10 percent, the second borrower gets debt forgiveness, while the first one doesn't. Perhaps the first casualty of financial crises is fairness, but as a policy matter, it is hard to ignore the problem.

The fairness issue is not insurmountable--irresponsible homeowners get hurt almost as badly as irresponsible ones if foreclosures flood their neighborhood. But the first point is killer. It may be economically irrational, but people do not calculate the price they are willing to pay based on how much the house is worth to them; they calculate it by how much mortgage they can afford on their monthly salary. Having the government abrogate legal contracts, whether by freezing interest rates, forcing lenders to write down the value of the loans, or another means, will make them much less willing to lend in the future. Indeed, some of them will be less willing to lend because they will be bankrupt. If the supply of credit contracts, the price of credit--i.e., the interest rate--will rise. And if interest rates rise, the price of housing will fall still further, because at higher interest rates, buyers can only afford to take out a smaller loan. That will put many buyers, including the subprime ones, deeper under water. The cure seems worse than the disease.