The government sure has a funny prescription for restoring confidence in America's credit markets. It purports to solve the nation's credit crunch — a slowdown stemming from investors' loss of trust in instruments such as mortgage-backed securities — by pressuring millions of borrowers and lenders to renege on their contracts and bilk mortgage investors.
Whatever relief the plan hatched by Treasury Secretary Henry Paulson to freeze the introductory interest rates of adjustable-rate mortgages (ARMs) gives to some borrowers today, it is almost certain to hurt many more borrowers in the future. Instead of going after the real instances of fraud, Paulson set a sweeping standard for a wide swath of borrowers and lenders to back out of consensual agreements. If this precedent of the government arbitrarily pushing through changes to contract terms is allowed to stand, it will make many legitimate businesses think twice about investing in the U.S. credit markets and increase costs for loans.
At the least, the Paulson plan is unnecessary. It is true that lenders are better off if they modify loans to troubled borrowers than if borrowers enter foreclosure. But it doesn't follow that government needs to coordinate these efforts to bring all the players together, as defenders of this bailout claim. Banks and borrowers have the incentive to get in touch and negotiate agreeable terms. And Paulson really can't make the process move any faster. Treasury Department employees are not going to get on the phone and contact troubled borrowers. All his plan will do is set forth a broad category of borrowers eligible for relief that, contrary to the plan's intention, may include speculators and flippers who filed false paperwork.
Unless there was fraud, both borrowers and lenders should be expected to live up to the terms of their contract, unless they mutually agree to changes. Innovations such as ARMs enabled many smart borrowers to improve their prospects by using the extra cash flow for purposes such as starting a business or getting a new degree. These responsible borrowers and their lenders should not be punished for the imprudence of others.