There was an interesting exchange on subprime mortgages between Barack Obama and Hillary Clinton during their last debate. Hillary argued for a mortgage freeze (hat tip: Instapundit):

I think it's imperative that we approach this mortgage crisis with the seriousness that it is presenting. There are 95,000 homes in foreclosure in California right now. I want a moratorium on foreclosures for 90 days so we can try to work out keeping people in their homes instead of having them lose their homes, and I want to freeze interest rates for five years.

Obama pointed out a serious flaw in her proposal:

On the mortgage crisis, again, we both believe that this is a critical problem. It's a huge problem in California and all across the country. And we agree that we have to keep people in their homes.

I have put forward a $10 billion home foreclosure prevention fund that would help to bridge the lender and the borrower so that people can stay in their homes.

I have not signed on to the notion of an interest rates freeze, and the reason is not because we need to protect the banks. The problem is, is that if we have such a freeze, mortgage interest rates will go up across the board and you will have a lot of people who are currently trying to get mortgages who will actually have more of a difficult time.

Obama is right to point out that Hillary's proposed mortgage freeze would create perverse incentives. But his own proposal for a bailout has a similar weakness. If the government bails out subprime borrowers and lenders who made bad decisions, that will create incentives for future borrowers and lenders to take unjustified risks of their own. The end result will be a serious moral hazard that leads to overinvestment in overvalued real estate - drawing funds away from potentially more productive uses elsewhere. Both borrowers and lenders will expect the government to bail them out if future risky morgages go into default.

In addition, as I emphasize in this post, a bailout would impose large costs on innocent third parties: the taxpayers. If we genuinely want to prevent unwise mortgage borrowing while simultaneously protecting the interests of future homebuyers and innocent third parties, the right strategy may well be for government to do little or nothing. If both lenders and borrowers have to pay the price for their mistakes, they will be less likely to repeat them.