I, Mortgage — The case against Paulson’s contract nullification bailout

“Wall Street Falls on Mortgage Unease” read the headline of an Associated Press story posted on Yahoo Finance just after the markets closed on Monday of this week. The headline was fairly typical of financial stories of the last few months, as the stock market has see-sawed due to mortgage woes and fears of a broader impact on the economy. The article noted that “the stock market’s decline followed a week in which the Dow Jones industrial average made its biggest weekly point gain in more than four years.”

But then the story noted something unusual. This day, the factor wasn’t a new spike in foreclosures or a big bank’s announcement of expected losses from mortgage-backed securities. Rather, the government’s own announcement of an impending mortgage rescue plan may have reignited the market’s nervousness.

That day, at a housing forum, Treasury Secretary Hank Paulson announced details of a government plan in which several financial institutions would “voluntarily” agree to freeze interest rates about to reset on adjustable-rate mortgages. “Nothing is worse than doing nothing,” Paulson said in the speech.

But the markets seemed to be of a different opinion: some things were worse than doing nothing, and those “some things” may include Paulson’s plan. “Investors appeared unsure about a government-sponsored rescue plan for the mortgage industry,” the AP story observed.

The stock market’s reaction was in sync with that of the futures market, where Paulson’s plan also went over like a lead balloon. As noted in a commentary by Bear Stearns analysts Peter DiMartino and Steven Bergantino, although the ABX derivatives market “at first reacted favorably,” by the close of trading last Friday, “investors were no longer of the mind that the plan would have any positive influences on expected losses in the subprime sector.”

No one knows how the markets will react to the White House’s official unveiling of the plan tomorrow. But if it’s anything like the initial description by Paulson and others, there’s good reason for conservatives to share the market’s initial nervousness. According to the latest reports, the administration has hammered together an agreement with some of the biggest lenders to freeze the introductory rates for certain borrowers for as long as five years.

At the very least, if the Paulson plan is truly voluntary, it’s unnecessary. Paulson starts from an initial premise that is indeed correct: that banks and investors who hold and service loans are better off with reduced payments from loan modifications than with no payments due to a troubled borrower defaulting in a foreclosure. Contrary to TV and movie portrayal of greedy bankers just waiting for the chance to foreclose on a home,

But it doesn’t follow from that that government is necessary to create a reduced payment plan for millions of borrowers. Loan holders and servicers have plenty of incentive to do that themselves.

Paulson’s flawed assumption is thinking complexity in an economic transaction — in this case, the diverse numbers of new players in the mortgage market — justifies government intervention in rewriting lending agreements. In a statement in his speech on Monday, Paulson said, “An appropriate role for government is to bring the private sector together when innovation has greatly increased the complexity of achieving beneficial solutions for all parties involved.”

This statement, as well as the plan in general, has been given a lot of backhanded compliments from liberal pundits. They (rightly) perceive it as a top Republican official conceding their big-government arguments. Salon.com columnist Andrew Leonard wrote gleefully on Monday that this “one sentence delivered by Paulson … profoundly undermines the political logic of laissez-faire capitalism in the 21st century.” Leonard goes on to conclude that because there are “billions of people all over the world innovating their hearts out,” this, “by Paulson’s logic, will mean that the future inevitably will offer increased opportunities for government to play its appropriate role in knocking heads, taking names and ‘achieving beneficial solutions for all parties involved.’”

But increased complexity means nothing of the sort, for mortgages or any other product. Markets for many devices had a complex array of players long before the iPod or the adjustable-rate mortgages. In his classic 1958 essay “I, Pencil” — an essay lauded by Milton Friedman and Ronald Reagan — Foundation for Economic Education founder Leonard Reed asserted that “not a single person on the face of this earth knows how to make” a pencil. He then explained that the manufacturing of a simple pencil involved transactions from the logging of trees in the Pacific Northwest to the mining of graphite in Sri Lanka, as well as all the transactions involved in the modern transport of pencils to their users by trains, trucks and ships. In his book Free to Choose, the late economist Friedman added, “It is even more astounding that the pencil was ever produced. No one sitting in a central office gave orders to these thousands of people.”

And no one sitting in a central office can hope to set the right mortgage terms for millions of borrowers, lenders and investors. Mortgages, of course, have many differences than pencils. But the tailoring of a product to an individual need cuts even further against the argument for central government planning. No matter how much pressure the government can put on industry players, Treasury Department officials are not going to be manning the phones and contacting delinquent borrowers to calculate what payment plan is best for them. In the absence of getting rid of regulatory barriers to loan modifications, such as accounting rules that count some loan modifications automatically as lender losses (I’ll have more on this in future writings), there is very little the government can do to make the process more efficient.

So like all so-called five-year plans, the five-year interest rate freeze by its design would pretty much have only negative effects and worsen the credit slowdown. While apparently no taxpayer dollars are directly involved (at least not yet), by pressuring the rewrite of millions of mortgage contracts, the Paulson plan could have even greater costs on the economy as well as future aspiring homeowners than even a direct taxpayer bailout. The credit market depends on the sanctity of contracts for everything from the financing of mortgages to new small businesses. But if regulators can negate contracts anytime there is a problem, much of this credit could dry up. As financial analysts DiMartino and Bergantino write, “if lenders and investors believe the agreements that borrowers sign could be altered by legislators or regulators, they may be hesitant to provide capital/liquidity, or at least require a higher risk premium.”

And also a higher political premium for Bush and for the GOP if it backs him on this, and the credit market further diminishes This is a great time for conservative presidential candidates to show where they differ from Bush. It’s also a great time to learn the real causes of the Great Depression. In her brilliant new book, The Forgotten Man, Amity Shlaes shows how interventionist policies both by Herbert Hoover and then to a greater extent by Franklin D. Roosevelt turned what could have been a painful but temporary market correction into the Depression.

Right now, while foreclosure rates have significantly increased, the percentage of homes in foreclosure is still less than 1 percent, according to the respected National Delinquency Survey of the Mortgage Bankers Association. But the credit market is nervous because of housing market unpredictability and the flaws in methods it previously used for valuing mortgage-backed securities. The urge to “do something” by forcing the changing of contracts could make the credit market diminish even further.