Dissatisfaction Guaranteed: The federal government should stop guaranteeing loans

Each time an auto company, small business, or homeowner receives a politically motivated loan guarantee, the giveaway creates yet another unfunded liability for future taxpayers. Now, in response to the economic crisis, the feds have provided more than $8 trillion in new guarantees. Aside from attempting to halt an alarming decline in lending, the loans’ supporters give four justifications for the programs.

First, they claim certain entities are being denied access to credit through no fault of their own. Supposedly, even in boom times, lenders pass over many opportunities to issue loans to borrowers who, despite appearances to the contrary, are creditworthy. This argument sounds especially persuasive at a time like now, when interbank lending is frozen and subprime lending has disappeared.

Second, loan advocates argue that the recipients will generate economic growth that otherwise would not occur.

Third, they say additional social goods can be derived from goosing the credit markets. Widespread homeownership, for example, is seen as increasing the country’s stability and prosperity.

Finally, there is the notion that keeping particular firms alive enhances the common good, whether because they provide essential consumer services, add to competition in certain markets, or employ significant numbers of people. In some cases, politicians call for supplying credit to an entire industry (e.g., the banking system) or a huge portion of it (e.g., U.S.-owned automakers).

The federal government guarantees loans to induce banks to lend money to credit-risky borrowers. If the borrower defaults, the government reimburses the lender for either the entire loss that the lender would otherwise sustain or a large fraction of it. With this guarantee, banks are willing not only to lend money to high-risk borrowers who couldn’t get loans without it but also to grant more favorable terms to existing customers. [...]

Federally backed loans create a classic moral hazard. Because the loan amount is guaranteed, banks have less incentive to evaluate applicants thoroughly or apply proper oversight. Not only are the borrowers high-risk to begin with, but it’s not necessarily cost-effective for lenders to identify the best of these bad applicants.

These bad incentives are among the reasons for the financial crisis to begin with. For years, the government has encouraged banks to extend credit to noncreditworthy borrowers and to make larger loans than a market would normally bear even to creditworthy borrowers. It did this by explicitly and implicitly guaranteeing certain banks’ losses.

It’s irresponsible to keep encouraging banks to lend money to borrowers they wouldn’t assist if their own money were on the line. It is a good thing that banks today won’t lend money to people who can’t afford to pay it back. That doesn’t mean all credit markets are, or should be, frozen. Even in the current housing market, for instance, borrowers with decent credit histories and down payments still have access to mortgages.

It’s also worth noting that interbank lending froze completely when the bailout was announced. Why take the risk when Washington can force taxpayers to take it for you?