Paulson Vs. The Free Market
Joining the Fed's effort to meddle with the free market is Treasury Secretary Hank Paulson and his plan to rescue the housing market. The essence of his plan is to convince the owners of sub- prime adjustable mortgage debt to freeze the interest rate resets for a period of about five years, a proposal which is supposedly only to be available to those who will become indigent once the higher rates become effective. Ostensibly, this will ameliorate the anticipated surge in mortgage foreclosures and prevent a further decline in home prices.
The first reason to eschew Mr. Paulson's plan is that his deal, if successful, may serve to protract the issues with housing for years to come. Offering to freeze the rate for only those who cannot afford higher rates is silly and we will certainly see claims of indigence from many who can actually pay. Unfair speculation on my part? Just read this article on the amount of fraudulent Katrina aid relief claims.
After all, who would voluntarily pay the higher rate when they can keep their existing rate by pleading poverty? The result will be an even further decline in CDO prices and even less availability of credit, not more. At this time it is projected by HUD's Secretary Alphonso Jackson that no more than 25% of consumers will foreclose on their sub-prime loans. Which is better financially for the holders of these mortgage products, to have 75% pay the higher rate or to have nearly all sub-prime mortgage holders pay the introductory rate for five years or longer? I know which one is moral.
Another consequence of the Paulson plan will be that future loans will carry a much higher interest rate. Underwriters in the primary market and buyers in the secondary market must be compensated for the increased risk of having the government intervening in a private contract. If the government forces the abrogation of these contracts it will cause tremendous long term damage to the housing market. If it merely acts as a facilitator between the two parties the damage may be less but the impact will be negligible. Since the holders of the debt are no longer local banks but foreign buyers, I have my doubts as to Treasury's ability to bring any far-flung parties together. In addition, there is nothing currently preventing the parties from getting together if they both so desired--making Treasury's role a public relations move, at best, unspoken coercion, at worst.
Most importantly, Paulson's anti-capitalist plan serves to reward those who behaved irresponsibly and punish those who lived within their means. It will act as a disincentive for consumers who, during the housing bubble, either rented or purchased a more modest home while simultaneously rewarding consumers that spent recklessly! Not only is it morally bankrupt but is also detrimental to the economy in the long term because after the period of abeyance expires, the adjustable rate mortgages would theoretically reset. Therefore, all that is accomplished will be to prolong the inevitable crisis-does anyone truly expect those who got the free lunch to begin paying for it after five years? Those sloppy financial habits will only be more deeply ingrained by then.
In an attempt to aid the real estate market, the Treasury and Fed are actually serving to exacerbate the problems associated with housing. If they would allow the free market to work, home prices would fall, allowing solid buyers to enter the market at lower prices. Would it be a pain-free process? Certainly not-we're well past that point-but by keeping unqualified consumers as home owners they foster an artificial environment of unfairness and inflation. Mr. Paulson's scheme is thus destined to fail, and it will likely make today's housing-related problems even worse in the process.
*NOTE: I also discuss the upcoming Fed meeting and its implications as a guest in the final segment of this week's edition of Market Neutral. Click the link to listen!