Is Paulson’s mortgage-rate freeze really the ticket?

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In a speech today, Treasury Secretary Hank Paulson let slip a few more details about the plan to freeze rates on some adjustable rate mortgages so a few hundred thousand hardworking Americans who took out really crazy loans can hold on to their homes.

While the reality is a bit more complex, in the interest of simplicity, there are four categories of subprime borrowers. There are those who can afford their adjusted interest rate; these homeowners need no assistance. There are also a substantial number of homeowners who haven’t been making payments at the starter rate on their subprime loan and may not have the financial wherewithal to sustain home ownership; some of these homeowners will become renters again. A third category of homeowners might choose to refinance their mortgage – putting them in a sustainable mortgage while keeping investors whole. This is the first, best option. Servicers should move quickly to assist those who can refinance.

And the fourth category is those with steady incomes and relatively clean payment histories who could afford the lower introductory mortgage rate but cannot afford the higher adjusted rate. We are focusing on this group, determining who they are and what steps may appropriately assist them.

What exactly does this mean?

Calculated Risk sees it as forestalling the inevitable:

Whenever the freeze ends, most of the homeowners in the defined group will still face foreclosure. So the purpose of this plan is clear – since the industry lacks the infrastructure to handle the work load, this guideline helps decide which loans to foreclose on now, and which loans to foreclose on later.

Steve Randy Waldman sees deeper meanings:

The proposal effectively represents a transfer of wealth from junior to senior trancheholders. Which gets us to its clever systemic implications.

The current credit crunch stems not from the absolute scale of writedowns, but from the distribution of the losses. Highly leveraged entities with very little capacity to bear risk, who thought they were holding “supersenior” (but yield enhanced!) securities, are facing catastrophic unexpected losses. If those losses could be shifted to investors with a greater capacity to bear risk, the systemic implications would diminish towards the absolute scale of the losses, that is, towards insignificance.

Less senior trancheholders are being asked to take a hit, because they can, to save other investors who can’t afford their losses. From each according to his ability, to each according to his need. You’ve gotta love capitalism.

Elizabeth Warren has mixed feelings:

This negotiation over mortgage looks like a giant non-bankruptcy bankruptcy. By doing it as a one-time negotiation, perhaps it will be better suited to the immediate problem presented. On the other hand, by making this a one-time deal, does it stall the kind of legal change that would clean up the mortgage industry and that would help families whether they are the only one in trouble or one of two million?

My main thought is that the quickest way to get through the current housing mess is to recognize all the bad loans for what they are, kick people who can’t make their payments out of their houses (or come up with some kind of solution short of that through bankruptcy court), let mortgage investors take their lumps, shut down a few more lenders and get on with things. The fact that this didn’t happen in Japan in the early 1990s was one big reason why that country’s economic misery went on and on. In that light, any kind of a rate freeze seems like it would merely shove the day of reckoning into the future and thus prolong the misery.

But that stance doesn’t appear to be politically acceptable at the moment, partly because Congress, at the behest of the financial industry, kinda messed up the bankruptcy code a couple years ago. Also, given the apparent current fragility of the financial system, it may not make economic sense either. Which leaves us with Paulson’s stopgap. Still, I vote that we all hold out for Jubilee.