Saturday, December 1, 2007



The Street was abuzz yesterday (Friday, 11/30) about a plan being hatched in the Treasury Department that would freeze interest rates (temporarily, so it is said) on sub-prime home loans, often at the teaser rates that were, in many cases, the only rate at which the borrower could afford the home he or she bought.

There is nothing wrong with a borrower and a lender sitting down to negotiate a way to work out a loan that has gone, or soon will go, sour. After all, most homebuyers don’t want to be evicted and most lenders don’t want to repossess property, especially in a real estate market like this one. One of the obvious ways to avoid foreclosure is to prolong, temporarily or otherwise, rates at which the borrower can remain current. However, the Paulson plan has a distinctive malodorous pall to it for a number of reasons.

First, there is a heavy element of government coercion here. The whole arrangement does not appear to have the trappings of a freely negotiated deal between borrower and lender. The force of government is heavily involved here; if Fannie and Freddie, which hold, through securities or collateral, 15% of the sub-prime market, can be brought into the deal, the pressure will be intense on other lenders and investors to go along. The federal government obviously has enormous leverage with Fannie and Freddie. If government coercion is a key element of the plan, can a taxpayer financed subsidy to “disadvantaged” lenders or homeowners be far behind? Even if one is naïve enough to believe Hank Paulson’s protestations that no government money will be involved in his latest palliative, the generous application of the government strong-arm would itself be baleful enough.

Second, the days when the borrower could identify his lender (usually the green eye-shaded Mr. Barsaszkas in the imposing greystone called an S&L down the street) and sit down to negotiate with him are long over. The typical borrower’s loan has been sliced and diced into dozens or hundreds of securities held by investors worldwide. The lender must negotiate with the loan servicer, whose powers to negotiate are murky and therefore conducive to litigation. Even if those cases in which the servicers’ power to negotiate is clearly spelled out, there is something wrong with a situation in which servicers are responding to ukases from Washington to negotiate solutions that might not be in the interests of the investors in the loans they service. As Mark Adelson, a money manager quoted in The Wall Street Journal, said

“There is a part of this that’s just morally repugnant. The problem is that policy makers are talking to servicers about giving away other people’s money.”

Third, no one is talking about disclosure yet. While this might come out in the details, it is imperative that, if these loans are renegotiated, they be written down to reflect the reduced cash flows they will generate. Much of the “sub-prime problem” has been exacerbated, indeed created, by an effort to paper over underlying financial difficulties. A “solution” that does not involve full disclosure could be counterproductive.

Fourth, this “solution” ignores the worst manifestations of the underlying problem. Many, if not most, of these loans are bad loans even at the existing interest rate. In fact, while details of the Paulson plan remain scarce, such loans would not even be covered by the plan, a rare concession to reality on the part of policymakers. So if the Paulson plan only covers those mortgage loans that could be saved by an extension of the teaser period, a substantial chunk of the sub-prime mortgage loans are going to fail despite the plan. Further, even those loans that are “salvaged” will fail when the postponed reset finally takes place. Thus, for many of these loans, this is merely a call for the governor on Christmas Eve to put off the execution until after the holidays. The miscreant will die; he will merely be given the “gift” of another week or so to think about it. The “homeowner,” knowing that he will lose his home anyway, will let the property fall into further neglect, decreasing its value. As Alan Fournier, another astute fund manager quoted by the Journal said

“This reduces the pressure short term to bring everything to a clearing price. We really just need to let it wash through.”

(Messrs. Adelson and Fournier are very astute fund managers, regular readers of the Insightful Pontificator, or both. But I digress.)

It’s even worse than Mr. Fournier and most people suppose. The Paulson plan has been hatched under the mistaken impression that the problem we are witnessing is a sub-prime mortgage problem. As I said months ago, and the rest of the world started to realize much later, this is a debt problem that extends far beyond sub-prime home mortgages. As a society, we have borrowed far too much without the means to repay what we have borrowed. Self-styled financial geniuses have convinced themselves, and the supposed moneyed cognoscenti, that the resultant high levels of risk could be eliminated by the application of Rube Goldbergesque financial engineering techniques even the creators of which, as it turned out, didn’t understand.

So it looks like this latest plan being forced down the throats of the markets and the economy by the central planners of the Bush administration will be merely a band-aid, a band-aid applied before antiseptic that serves only to let the underlying infection fester and spread.

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