President Bush certainly appeared to be a populist this week.

"The homeowners deserve our help," President Bush said at a press conference this morning. "The steps I've outlined today are a sensible response to a serious challenge."
Officials said 1.2 million borrowers nationwide would be eligible for assistance.

Bush's plan calls for a freezing of mortgage rate resets for subprime borrowers who bought at the top of a huge real estate bubble. Best of all, it doesn't involve any taxpayer money...well, sort of. I'll address that later.

The fact is that this is a bailout, and in a bailout someone is going to have to pay for it. And that's where we have a problem.

"...recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade...American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage."

- Fed Chairman Alan Greenspan, February 23, 2004

So if the taxpayer isn't going to pay, then who pays? The investor will pay.

``Simply freezing interest rates on some U.S. first-lien subprime mortgage loans would have a negative impact'' on ratings of some residential mortgage-backed securities, analysts at New York-based S&P wrote in a report today. S&P said modifications to the loans will mean reduced payments available to investors from creditworthy borrowers.

To put it simply, locking in those "teaser" rates means less interest is being paid on the mortgages.

Now you may think that the choice of who pays for this bailout is either the subprime borrowers who lose their homes, or the big lenders who were so greedy that they made stupid loans. You would be wrong.

In today's world the mortgage lender unloads the mortgage as quickly as possible.

They package it up in a Mortgage-Backed Security (MBS) and sell it on Wall Street. Thus they offload the risk onto the investor.

Who is the investor? Why its pension funds, mutual funds, foreign investors, and insurance companies. Have you looked in your 401k recently? If you own a bond fund then chances are you have some MBS's in it. The stuff is everywhere.


And its not like the government hasn't already been trying to bail out the subprime borrowers. Local governments have been trying, and failing, to bail out these foolish people.

Eight states, including Massachusetts, Maryland, Ohio, and Pennsylvania, have pledged a collective $900 million towards the foreclosure crisis since the beginning of this year according to a Boston Globe report. The money was meant to help people refinance out of unaffordable loans, but things aren't working as well as planned.

A Globe survey found the raised cash has actually helped less than 100 people refinance.

Bush's plan make it legal for state and local governments to use muni bonds (bonds backed by taxpayers) to bail out the subprime borrowers. Judging by this track record, it is doomed to failure.




There are so many reasons why this plan won't work it is hard to list them all. So let's start with the obvious.

One mortgage executive told us that the big problem is payment-option ARMs where the consumer has a rate of 3%. A rate that low cannot be artificially maintained by servicers. In other words, if Treasury thinks a servicer (or end investor) will roll over a 3% rate, the government is dreaming.

One industry veteran — requesting his name not be used — raised another issue: ‘OK, so you keep the rate the same for the subprime borrower. Then the prime borrower who has been current all along and who also has an ARM says, ‘Hey me too. Keep my rate the same.'
This industry vet said Treasury has to either come up with a plan where all ARM rates are frozen or none are. ‘Think about the lawsuits,' he said.

For starters, a 3% rate is not sustainable at market rates (i.e. no one will want to buy it).

Then there is the problem of classification. Who is subprime and who isn't?

Group 4 includes those who can continue to make their mortgage payments if the teaser rate stays in effect or the maturity of the loan is extended. For this category, and this category alone, help is on the way.

How do you spell b-u-r-e-a-u-c-r-a-t-i-c n-i-g-h-t-m-a-r-e? If fraud was widespread during the housing bubble, the current plan has its own set of incentives.

''People will come up with eight ways of rearranging their finances to stay in Group 4,'' said Ram Bhagavatula, managing director at Combinatorics Capital LLC, a New York hedge fund.

Even if there is an agreed upon limit for being "subprime", let's say its a credit score of 620, what about the guy with a credit score of 640? Do you think he's going to be happy about missing out on this bailout? He's either going to cheat to get under the limit, or he's going to scream bloody murder and call his attorney.

But wait, it gets better.

While Paulson has been busy devising a plan that limits the damage to the economy without encouraging more risk-taking in the future, ''Treasury hasn't thought through'' one aspect of the plan, Rosner said: the implication for Fannie Mae and Freddie Mac, the two government-sponsored mortgage behemoths.

''Guess who's the largest single holder of AAA notes? Fannie and Freddie,'' he said.

That's right, the biggest investors who will pay for this bailout also happen to be Government-Sponsored Enterprises that have an implicit backing of the U.S. Taxpayer. So if Fannie Mae and Freddie Mac go under because Bush's plan, then it will be Mr. and Mrs. Taxpayer that will have to bail them out.

But wait, it just keeps getting better.

Unaffordable loans don't cause foreclosures directly. Even as subprime lending became more common, even when people fell behind on mortgage payments - during the economic downturn in 2001, for example - foreclosures were rare because house prices continued to rise.

In part, people were able to escape trouble by selling their homes at prices high enough to cover their debts. But the research also suggests that troubled borrowers tried harder to make the necessary payments, in the expectation they would profit eventually.

Conversely, when prices started falling, people struggling to make payments had less incentive to find the money. And the value of the home could drop below the outstanding debt, making it impossible to sell. Over the last two years, the number of foreclosures exploded.

To put it simply, it isn't the resetting of mortgage rates that are causing the huge spike in foreclosures. It's the falling home prices that are causing the huge spike in foreclosures.

Will Bush's plan cause home prices to stop falling? No!
The only thing that will cause home prices to stop falling is a drop in home inventory, and that will simply take a while to happen. Probably several years.


Instead, what Bush's plan will do is force banks to hold bad loans, loans that are in technical default, on their books for years and years to come.
If that sounds familiar, it is. Japanese banks did this exact same thing in the 1990's after their real estate bubble crashed. Did they stop their real estate market from imploding? No. Japanese real estate prices continued to collapse for 15 years until they reached the level they were at before the real estate bubble started.

Japanese banks then became reluctant lenders because they had to keep a lot of cash on hand in case they had to cover these non-performing loans. The economy continued to struggle despite the government lowering borrowing rates to zero and keeping them there.


Is that what we are in for? If we were only so lucky.

Japan could keep interest rates that low because they were some of the biggest savers in the world and retained a trade surplus the whole time.
Americans don't save any money, nor do they make things that they rest of the world wants to buy. If we drop interest rates to zero then no one will loan us any money. If foreigners don't loan us any money then our economy will have no capital, and thus it will crash.

But even before that, the dollar will collapse if the Fed lowers interest rates to near zero.