...And You Remove All Reason and Logic

The New Yorker has this analysis of the rate freeze that Secretary Paulson has brokered. It focuses on only one of the five points of why I thought this rate freeze is bad and dangerous policy. It does concur on that point, which is that this rate freeze will only marginally help those it intends to anyway.

Although the plan will provide real relief for at least some homeowners, it’s more like a Band-Aid than like the major surgery that some of the hype makes out. That’s because at this point interest-rate resets are just a small part of the mortgage-market problem. Postponing rate resets doesn’t change the fact that too many people spent far too much borrowed money on houses with prices that were far too high, and that they are now stuck in homes that they can’t really afford and can’t sell. Even with the interest-rate freeze, foreclosures will keep rising

I believe the article is largely right, and from experience I believe that most sub prime borrowers just simply overbought. They took on property they couldn't afford. I believe that the rate increase would only perpetuate not create the problem. (Please note there is a great deal of debate on this point within the industry so my view is not a given. Some people do believe that it was in fact the rate increase that started the problem).

That said, there was something else in the article that is even more concerning.

Not for everyone, though. The plan sets up a system of triage, separating borrowers into three categories: those who will be able to keep paying after the rates reset, or else refinance their loans; those who can pay now but won’t be able to when the rates go higher; and those for whom even the current rates are too high. Only the second group will get help. Also, the plan doesn’t go into effect until next year—if your loan resets on December 31st, you’re out of luck.

In other words, what this plan will do is punish responsible borrowers and reward irresponsible borrowers. Think about what this article is saying for a minute. If you happen to be holding onto a subprime loan and you can afford the new higher payment, the rate freeze doesn't apply to you and you are forced to take that higher payment. If, on the other hand, you could afford the lower payment but not the new payment, you will have your lower payment frozen for you. Does this make any sense? How could the government possibly institute a policy that rewards irresponsible borrowers and punish responsible borrowers and think this will have anything but a disastrous effect?

Furthermore, how exactly is one to determine who can and can't afford the payments? They are going to freeze rates that are going to reset in the future. We are talking about millions of loans. What are the parameters? Who will decide? How can this turn into anything but a bureaucratic nightmare? This is a process that will be ripe for fraud, manipulation, and chaos. Again, this is a textbook example of a moral hazard. Government continues to believe that they can create a moral hazard with a positive outcome, however they do it by removing all logic and reason.

This process is going to fraught with litigation. Imagine if you are one of the borrowers that is determined to be able to pay the new loan, what is the likelihood that you will look to sue to drop your rate? What if you were a borrower that was wise enough to take a higher fixed rate? What is the likelihood you will look to have your rate lowered artificially? How can anyone possibly justify rewarding the irresponsible while punishing the responsible? There is no way this would pass legal mustard. The worst part is the absurdity is spelled out in the plan itself.