Adam Smith must be rolling over in his grave right now

Arguably the father of modern economics, Adam Smith was a proponent of a Laissez-Faire style of economics.  Translation: government does as little as possible and the natural laws of supply and demand will determine price levels and purge the market of any impurities.  Very much a “might makes right” kind of approach.  Admittedly, there are certain functions that government must perform in a regulatory capacity to keep the playing field level, but things seem to have gotten out of hand.  Exactly like a drug-addict, we are addicted to economic intervention by our leaders.
 
Put yourself in the shoes of a big-time investor for a second.  Let’s say you bought a heap of stock that paid dividends well below normal market levels however you knew it would balloon into beautiful returns two years down the road, guaranteed.  Two years later, the numbers change and the returns jump up to very attractive levels.  But your dividends don’t change.  Not one iota.  You furiously call up your stock broker and he simply says “Oh, they needed more time at the initial rate.  Tough times out there.  Just give them another 5 years.”
 
The Big FreezeHow does that make you feel about that investment?  Like not investing in it, perhaps?
 
That’s exactly the story in the world of the mortgage-backed securities market.  President Bush is outlining a proposal to freeze adjustable rate mortgage interest rates at the “teaser” rate for 5 years if homeowners can prove that they are making the payments now and will not be able to make the payments later.  This means that the difference between what was promised to the investors and what they are actually going to get is going to hit somewhere, and it is going to hit hard.  Reduced confidence in mortgage-backed securities (if it CAN be reduced any further) will force consumer interest rates up to compensate for the loss of returns.
 
Interest rate resets are guaranteed to be unfair.  The debate then becomes the net gain of saving homeowners who were duped by shoddy business practices versus the net cost of bailing out greedy consumers who knowingly bit off way more than they could chew.  Are we willing to pay for market stability?  What message are our leaders sending when this economic cycle inevitably comes full circle and people have the chance to repeat their mistakes en masse?  If not this plan, then what other plan is available?  Do we enact a plan at all?  What about the prime borrowers with ARMs?  Are we going to punish them for having good credit when they closed?  Do I smell a huge pile of lawsuits?  What about the lenders that wrote the loans based on the promise of higher returns during the adjustment period?  Won’t that cause a huge second wave of financial write-downs?
 
Standards for determining homeowner eligibility for the rate freezes are also very open to interpretation.  Targeting only the segment of people who can afford the payments now but can’t afford the payments when their rate adjusts will prove to be very tricky.  Desperate homeowners will do whatever is necessary, legal or otherwise, to ensure that they can qualify for the freeze, heaping a whole new set of problems on the proposal.
 
Don’t get me wrong: I will be a direct beneficiary of this legislation.  Lots of us will be.  But, like sealing a still-infected wound, it’s a breeding ground for future problems.  I wish I could offer more answers, but all the market seems to be tossing us is more questions.  Food for thought.
 

12 Comments

  1. It is about time we observe from the other side of the mountain. When government steps in it allows for lack of accountability. Accountability we must face and understand in order to learn and grow. Without we slowly but surely approach a state of socialism. That is not what America is about. Let the markets select there own course.

    Three cheers for Greg!!!

  2. A key ingredient for markets to function perfectly is perfect knowledge. The rating agencies and the packagers of the various CDO and SIV products did all they could to pretend that risk had been eliminated from these bundled mortgage products. That was a mistake. Should the bond raters and bundlers make investors whole?

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