Ask the editors: Isn't a mortgage cramdown just price fixing?

By Megan McArdle

The short answer:  no.  The long answer:  the mortgage cramdown is, in the words of Eddie Murphy, like Kibbles and Bits . . . the same, but different.   


Price fixing just tells suppliers that there is a new, fixed price that they can't sell above.  The result is that suppliers who cannot make money at that price leave the market, resulting in fewer units available.


Price fixing.jpg

The red triangle is the deadweight loss of the price floor, representing people who would have been happy to buy at the old price, but now cannot get any of the item at all, because fewer units are being supplied.

Mortgage lenders who see mortgage cramdowns rise will also, many of them, find that they cannot lend profitably at old rates.  But mortgage lenders don't have to exit the market; they can also raise prices.

Of course, many buyers with shakier credit will find that they cannot afford the higher prices; from their perspective, it doesn't really matter whether the credit rationing comes from higher prices, or reduced supply.

In one way, however, mortgage cramdowns are worse than a price ceiling.  Price ceilings are predictible.  Mortgage cramdowns change your cost structure variably.  In the short term, many mortgage lenders will undoubtedly ration credit by refusing to extend it to many markets, because they cannot predict how many people will take advantage of the cramdown.  In the long run, the cramdown introduces a variable element to mortgage lending costs.  Worse, that element is what we call pro-cyclical--during booms, your cost goes down, while during busts, it goes up.  This is already substantially true of financial services companies, which do better than the broader economy during booms, and worse during busts.

Because the effect of busts is somewhat unpredictible, companies will have to cut back on their lending in many markets to build up reserves during good times (and avoid spending them down in bad times).  This means that an already contracting credit sector should contract further.

This article available online at:

http://www.theatlantic.com/business/archive/2009/03/ask-the-editors-isnt-a-mortgage-cramdown-just-price-fixing/1322/