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December 7, 2007
Freeze! Your Under House Arrest
Terrified by the threat of bankrupt homeowners be able to go to the courts to renegotiate their mortgages (a Democrat plan), mortgage lenders/investors agreed to play ball with Paulson’s rate freeze scheme. Ironically, left out of this scheme - which has voluntary aspects to it - is the struggling U.S. homeowner. To be sure, those homeowners that have already fallen behind on their mortgages, have taken too much equity out of their homes, and/or do not have the correct credit score, have been left to fend for themselves.
A couple of questions following yesterday’s subprime bailout (incidentally, although the U.S. government is not putting up any direct funds, the word ‘bailout’ is applicable because by entering negotiations directly the reputations of Paulson, and to a lesser degree Bush, have been put on the line):
- If U.S. interest rates skyrocket after homeowners get locked into a 5-year rate freeze will many subprime securities end up being perpetually toxic and/or difficult to value?
- Is it worth saving some homeowners if this makes it potentially more difficult to value subprime paper for an extremely long period of time?
- Is it possible that 5-years from now investors will be dreading the upcoming rate freeze resets and/or that Paulson’s plan will actually prolong the U.S. housing slump?
- What happens if the plan is a complete failure and very few homeowners actually get the assistance supposedly promised? (i.e. who is left to churn out the next bailout?)
- Was it by coincidence that Paulson and Bush announced their subprime scheme on the same day a landslide of negative housing news crossed the wires?
These are only a couple of the many questions that immediately spring to mind. On the positive side of things, fewer foreclosures means that fewer homes will be dumped into the already heavily saturated U.S. housing market. Anything that may help stem the housing price slide is clearly a positive in the mind of policy makers.
What’s Next? Cheaper money, of course
Following yesterdays subprime bailout investor’s eagerly await next weeks Fed rate cut and, with any luck, another bailout orchestrated by Paulson (SIV superfund). At the risk of straying off topic, isn’t it amazing that no government official (with the exception of Ron Paul) dares question exactly how Fed rate cuts stimulate economic activity? Does this silence imply that everyone in Washington thinks that when the Fed lowers interest rates funds are efficiently borrowed from the Fed and lent out to suitable borrowers that have carefully planned for the use of the funds? Judging by the contradictory themes presented below, apparently this is the case:
Congressman says: We need to bailout subprime borrowers!
Then Congressman adds: The Fed needs to cut interest rates to combat the threat of recession!
The stimulatory concept behind Fed rate cuts is to expand credit. On a very basic level rate cuts achieve this by helping create more favorable spreads for the banks which trickle down to borrowers, while the more complex story has to do with ‘real’ interest rates and leverage. Regardless, and to reiterate: the stimulatory concept behind Fed rate cuts is to expand credit.
Is it just me, or is anyone who screams ‘bailout!’ and then immediately afterwards calls for ‘more cheap credit!’ just plain nuts? After all, the bailouts in the works today are partially the result of too much credit!
Policy makers need to attack the lack of transparency in the marketplace
Following the LTCM crisis the Fed and SEC could have easily forced hedge funds to adopt some very basic standards (like telling potential investors that a fund manager was once a criminal before taking their money). The Fed and SEC failed. Following the Enron crisis FASB and the SEC could have easily forced companies to consolidate any and all off balance sheet assets. They tried, but failed. The lesson during both of these blowups was that the window for regulatory change can open and close very quickly.
Following the blowup of the U.S. housing market in 2007 policy makers are not gearing up any major developments on the regulatory front. Instead they are directly intervening in supposedly free markets and are bickering over whether or not the subprime bailout is aggressive enough. Investors are left to deal with off balance sheet, SIV, and Level 3 uncertainties and potential homeowners needs degrees in mathematics and economics to figure out their mortgage applications.
As for the homeowner that wants to move out to upgrade/downgrade in say 3 rather than 5-years time, Lord only knows what tiny print will be hidden in the renegotiated subprime contract trying to ensure that the homeowner stays put so investors get their expected return on investment. I can hear the banks now: ‘we did you a favor giving you a subprime mortgage and we are doing you a favor by letting you take advantage of a 5-year interest rate freeze. All we ask in return is that you keep up your end of the bargain for 5-years or risk the wrath of our lawyers...’
Given that the subprime fiasco was at least partially caused by confusing mortgage applications, the least Paulson and company could have done was come up with a simple bailout model (PDF).
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