Paulson's Plan: A Misguided 'Fix' to Market Dynamics

Treasury Secretary Henry Paulson has proposed a plan to help homeowners by freezing rates on adjustable rate mortgages. Readers can see the details of the plan on many sites, including here.

I'm a free market guy and any time the government intervenes like this, I believe it generally creates unintended negative consequences.

Implicit in the plan is the notion of the "greater good" theory in which the government is willing to void (to a certain extent) bona fide contracts between a lender and a borrower. If a person expects to sell or move before the ARM adjusts but then can't or chooses not to, why should the government get involved? Because a large number of defaults would somehow hurt the economy.

It's a shame that whenever a financial crisis occurs, some feel a need to find out "who's to blame?" "The Corporation" is an easy target because too often the media portray companies as greedy oppressors of the weak and innocent. There may have been some shady mortgage lending practices out there and if any laws were broken, those law breakers should be punished. But if no laws were broken and the the majority of these mortgages were contracted between two parties reasonably aware the risks involved, why not let the market move to where it wants to go? Why should anyone who buys real estate receive any kind of help from the government?

The other shame here is that the government feels the need to "fix" something. In my view, nothing is broken other than common sense and risk assessments in lending practices. It's hard to repair these breaches simply by government fiat (in my best town crier voice: "It is hereby declared that people should stop doing dumb things...").

Citigroup's equity market strategist Tobias Tevokvich estimates that only 4-6% of all homes may be affected by such problems. It seems amazing to me that this small portion of the real estate market could create the kind of worry that would necessitate such a plan from Mr. Paulson.

All that said, the details of the plan are about what one would suspect from the government - an attempt to forestall the true pain from ARM adjustments until the market gets better.

Famous last words - "until the market gets better." An investment strategy based on hope is perhaps worse than no investment strategy at all.

It reminds me a bit of the infamous "Price Keeping Operation" alleged in Japan following the stock market decline of the early 1990s. Although widely denied by the government, it was broadly known that the government exerted pressure for pension funds and other institutional investors to prop up the equity market around 1992 just "until the market got better." Take a look at a chart of the Nikkei during the 1990s to see how effective this was.

The plan is not a good sign, in my view. It suggests that either the housing/mortgage problem is much greater than currently suspected by the market and intelligent market observers or the government is doing something unnecessary that looks good to win the favor of the populace.

Investment implications? Not sure, but probably not a positive for anything. Delaying marking to market any assets probably does more harm than good and may create a false sense that thing's are better than they really are.

Comments

[chancer]

Normally, I oppose such intervention. I also am not interested in bailing out: banks, investors, nor home buyers who over reached. But, in this case, I think the combination of falling home prices and ARM interest rate resets is worse for the economy than necessary all at once. The delay will spread out the pain over a longer period of time so that hopefully the consequences to the economy in general and consumer confidence will be reduced. The severity is reduced by reducing the numbers. The banks/mortgage investors are better off getting less interest than zero interest and a loss on loans in foreclosure.
Re. bank write downs, I really favor deeper and faster as better. I would like to see the FASB make a rule: When a firm cannot set a verifiable (independent and objective) value for an asset (subprime loan), they must write down 50% on the first pass. Subsequent write downs would then be less. Right now, CPA firms are accepting non-verifiable management opinions. Accounting rules prevent them from writing down so aggressively that they can be cited for establishing excessive reserves that can be used to "manage" profits.