With much carnage already evident, the subprime mortgage fiasco looks likely to claim more victims in coming months.  Why?  Because loans that featured low introductory or "teaser" interest rates set millions of time bombs ticking towards the day when rates would "reset" at much higher levels, leaving defaults, foreclosures, and homelessness in their wake and adding billions of dollars more in losses to the subprime portfolios of investors who bought bundles of the risky loans from Wall Street.

The situation calls for action, and Blawgletter applauds folks — like Treasury Secretary Henry Paulson — who want to head off further damage.  Mr. Paulson has a "market-based" plan.  Sounds good.  It aims to give borrowers and investors relief and to do so by rewriting terms of the contracts between them.  Hmm.  The scheme would thus give "servicing" firms, which collect payments and otherwise enforce the mortgages, flexibility to ignore rate increases if they think doing so would avoid default.  With the result that borrowers keep their homes and investors lose less.  That seems downright magical. 

We’ve pointed out that the plan has, uh, legal problems.  The servicing firms don’t have clear legal authority to waive the investors’ right to collect interest per the strict terms of the mortgage loan agreements.  Their flexibility indeed depends on whether granting grace en masse instead of on the traditional loan by loan basis counts as the "industry standard" despite the fact that it doesn’t even exist yet.  So the Paulson solution could easily self-destruct without achieving any practical good.

(The NYT would fix the problem by passing a federal law overriding the contracts between borrowers and investors and immunizing servicers from lawsuits.  That strikes us as an honest yet even worse way to go.)

But something else bothers us more than a clever-but-late-and-probably-defective-anyway approach.  The feds to date have done little to nothing to assure compensation to victims, punishment to wrongdoers, and prevention of future abuses.  You’d think that the Department of Justice would at least investigate the accounting firms, commercial and investment banks, and ratings firms that played an essential — and extremely lucrative — role in making the subprime fiasco possible.  You’d hope that the U.S. government would implement safeguards against excesses down the road.  You might even imagine the feds would encourage meritorious civil lawsuits.


What should we make of governmental kudos for a "market-based" plan that likely won’t work and in any event addresses only a small fraction of a problem that resulted from regulators’ letting the "market" do whatever it damn well pleased?  Harvard bankruptcy professor Elizabeth Warren says that the Paulson plan changes nothing.  But "the administration’s subprime mortgage plan is the bank lobby’s dream" because it will "sandbag" pending proposals to allow bankruptcy judges to modify mortgage terms.  By Jove, we think she’s got it.

Barry Barnett

Feedicon14x14_3 Adam Smith spoke of the invisible hand — not the magical pretend hand.