Bush's Subprime Plan Spells a Raw Deal for2008

Dec. 19 (Bloomberg) — There are two kinds of people in business: deal people and price people.

For deal people, it is all about the relationship. They want to gain advantage in a current relationship, or position themselves for the next relationship.

Price people don't want to hold hands. They want a number.

Day to day, this difference is merely one of style. But when it comes to a financial crisis, the distinction matters. In crises, prices are better than deals, even when the price is very low. A low price at least gives a market a clear data point from which to recover. A deal — the classic bailout package — by contrast can generate fresh confusion. The deal rescues one party and ignores or hurts the other. Deals also beget deals. The doubts persist, the agony lasts longer.

This is why it is a shame that President George W. Bush has chosen the "let's-make-a-deal" option for handling subprime mortgages. By playing Monty Hall, he has insured that the credit crisis is likely to endure through 2008.

The whole subprime problem can be seen as a consequence of too few prices and too many deals in the first place. The price of a standard fixed-rate mortgage is too high for many families, even at today's historically low rates. The appeal of the adjustable-rate loan, never mind that of the subprime no-doc mortgage, lay precisely in that it allowed borrowers to fool themselves about the true price of the debt they were assuming.

In addition, many Americans nowadays feel that housing is something they can expect from their relationship with government. Homeownership is the great American Dream, but it is also the great American Deal.

New Deal

That brings us to the other guilty parties in the current story. The U.S. government began talking about housing as part of our social contract back in the 1930s. Franklin Roosevelt was literally thinking of a deal — his New Deal — when he created the Federal National Mortgage Association, the forerunner of Fannie Mae. Fannie Mae and its twin in the mortgage-backed securities business, Freddie Mac, have spent generations fostering the perception that mortgages are entitlements.

Everyone talks about how hard it is to unbundle mortgage-backed securities. But the half-private, half-government status of Fannie and Freddie also makes such securities hard to price. Too often, profits in this sector depend on whom you know in Washington.

Under President Jimmy Carter, Congress passed the Community Reinvestment Act to prod banks into lending money to poor families — the price of the loan at issue was secondary. Banks that ignored the law ran the risk of seeing other crucial business, such as mergers, blocked. The Housing and Urban Development Department also pressured lenders. That was part of the deal. Maybe the Act was less important to groups that had an easier time borrowing, but they too expected and got a special deal: the home mortgage-interest deduction.

Fannie, Freddie

You can even argue that one of the causes of the current crisis was a deal-focused requirement introduced in 2004 by the department. It created purchase quotas for Fannie and Freddie. The two were required to buy loans in three categories: loans to low- and moderate-income families, loans made in troubled locations, and loans that were a cross between the two. Fannie and Freddie stopped looking at prices, and started worrying about the political deal — the obligation to meet their quotas.

Bush could have used the current crunch to move the housing culture away from deals and toward prices.

S&L Bailout

The first step would be to rid the financial system of the existing toxic subprime mortgages, for which there are no reliable market prices, and scaring banks from lending to other banks holding such mortgages. My Council on Foreign Relations colleague Benn Steil has suggested a short-term government program that would offer to buy up such mortgages on a deeply discounted and publicly disclosed price schedule.

Something like that happened during the savings-and-loan crisis of the early 1990s. President George H.W. Bush and Congress created the Resolution Trust Corp. to sort out the credit mess. Hundreds of thrifts failed. Hundreds of billions in assets were marked down. But at least they had prices. And the process was fast. Resolution Trust shut down a year earlier than scheduled.

That speed was one reason the U.S. recovered from the commercial real-estate bubble and Japan didn't. The Japanese commitment to relationships contributed to a decade of economic stagnation in that country.

'Teaser Rates'

The current Bush plan sounds too Japanese for comfort. His Federal Housing Administration is refinancing many thousands of troubled loans for families. Bush and Treasury Secretary Henry Paulson have also extracted a commitment of a five-year freeze on the low "teaser rates" on adjustable mortgages from companies and banks holding the debt.

The Bush administration would argue that its assorted little deals aren't as bad as the dangerous big deals of Bush opponents — the $5 billion in cash for troubled borrowers that presidential candidate Hillary Clinton calls for.

Still, the Bush plan will have consequences. They include higher mortgage rates and fewer loans as lenders recalibrate for increased political risk. For the country as a whole, it's hard to see how that is a good deal.

(Amity Shlaes, a senior fellow in economic history at the Council on Foreign Relations, is a Bloomberg News columnist. The opinions expressed are her own.)

© Copyright 2007 Bloomberg

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