Bush Bailout Plan Will Only Create More Problems

As most of you have probably already heard, Bush has proposed a new plan to supposedly save the U.S. housing market. The plan is that mortgage lenders will "voluntarily"(Which is to say, under the threat of legislation if they don't agree to it) freeze interest rates which were supposed to rise in coming months from the initial low "teaser" interest rates. My old friend Antony Mueller comments this plan with the words

"A plan that could have equally come out of the head of Chavez"

That is perhaps a slight exaggeration as [Hugo] Chavez would have probably proposed even more radical bailouts, and America's own "wanna be Chavez", Hillary Clinton, have indeed proposed even more radical measures, including a temporary ban on foreclosures. Yet certainly the Bush plan is still in the spirit of Chavez.

Notwithstanding me and Antony Mueller, almost everyone ,including the stock market, seems to think that this will somehow save the U.S. housing market.

However, it won't. There are several reasons for this. First of all, even if this is universally implemented and they somehow manage to neutralize law suits from bond holders who lose from this, it will only mean status quo. The deterioration in the housing market that we've seen so far occurred with those lower rates that will stay unchanged. This only means that the problems of sub-prime borrowers won't get worse still, not that they will decrease.

Second, the value of the loans for bond holders and others who have financed these mortgages were based on the assumption that these subprime borrowers would pay higher interest rates. If they don't, then the value of these holdings must be written down significantly-at least assuming honest accounting is used. And whether or not honest accounting will be used, this will impose significant losses for the lenders.

Proponents of the plan, like Nouriel Roubini, answer this argument by saying that the plan will limit defaults, and rising defaults would have also inflicted losses on the investors, losses that according to Roubini is higher than the losses from the lower interest rates. Yet Roubini merely asserts this without providing any statistical evidence of this claim. The same thing goes with his other assertion that the plan bails out people who are merely illiquid rather than insolvent. The massive increase in debt levels that I discussed in the previous post directly contradicts this claim. And as Roubini himself concedes, bailing out insolvent borrowers only postpones the problem of defaults.

Moreover, even if it were true that the losses would have been even greater assuming the plan hadn't been implemented, then it still remain the case that the value of these holdings is much lower than its current book values, meaning that there is a need for massive write downs.

And while perhaps the plan will limit the decline in the housing market in the short term, the long term consequences will be very negative as this first of all slows down the adjustment to a more sustainable level of house prices and construction activity. Moreover, it will encourage irresponsible borrowing and so create more problems in the future as people learn that politicians will bail them out if. The plan will thus in the long term create a lot more problems than it solves.