Nice To Know Henry Paulson Agrees a Loan Guarantee Will Not Work

Today’s Wall Street Journal shed some new light on the Government’s plan to create a loan guarantee program. The article indicates that Henry Paulson seems to agree with my analysis that a programs only targeting interest rates will not solve the fundamentals of the mortgage crisis, namely that the average troubled borrower is overleveraged. The October 30th New York Times article was a bit vague on detail for the loan guarantee and led me to believe this was a program being pushed by the Treasury. Today’s WSJ (sorry the website link above is subscription only, it appears p. A2 in the paper) describes the plan as one of several plans the White House is considering, and is being formulated and pushed by the FDIC, not the Treasury.

Mr. Paletta and Mrs. Solomon, the WSJ authors, briefly outline Mr. Paulson’s objection with the plan. The authors write, “Treasury Secretary Henry Paulson agrees with FDIC Chairman Sheila Bair that the administration needs to take additional steps to help homeowners, but has concerns with some aspects of Ms. Bair’s proposal… Among his concerns is that sharing eventual losses with the government could give lenders an incentive to push homeowners into foreclosure.” Secretary Paulson seems to share a concern I outlined in “When government becomes a bank, anyone else concerned with moral hazard? (part 1 of 3)”. My concern which Secretary seems to share, is that a guarantee may make the crisis worse by putting a new and dangerous incentive structure in place to encourage foreclosure.

As the recession deepens high risk borrowers become even riskier. To keep interest rates artificially low (perhaps as low as 3% ) the government will have to increase the guarantee to compensate. At some point the guarantee will be so high a bank will be better off cutting their losses and foreclosing on a property, selling it at auction, and collecting the government guarantee. It is an important concern that the FDIC should really consider when pushing their plan.

Further I think it is important to note the WSJ article does not address how a guarantee could address the fundamental problem that many homeowners are overleveraged. Without addressing how to manage exorbitant principles that were incurred during the real estate bubble, I do not believe the plan can be considered a comprehensive policy that creates an effective market structures.

The article also did not elaborate on any key details for government restrictions on restructured loans, which may make this program even less effective because it adds cost and reduces flexibility.

I am pleased to see that Secretary Paulson is insisting we do not hurry into a program because it sounds advantageous politically, but rather insists on creating policies that create effective market structures.


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