December 8, 2007

A Market Free Of Consequences Is Not Free

For an administration eager to promote policies of free trade and free markets, the Bush White House seems unwilling to live by its consequences. Instead of allowing the mortgage market to operate freely, the Treasury Department will force lenders to freeze adjustable-rate mortgages at artificially low interest rates to keep bad loans from defaulting -- at least for now. The five-year freeze essentially removes the obvious inherent risk of ARMs, forcing lenders to further subsidize those who chose unwisely.

Mark Steyn takes up the topic in today's column (via McQ at QandO):

Last week the Bush administration decided to "freeze" for five years the interest rates of certain types of mortgages. You've probably caught the tail end of news stories about "subprime" home loans, lots of foreclosures, etc. Never a happy moment when the bank takes the farm.

So now the government has stepped in and said that, if you fall into a particular category of adjustable-rate mortgage (ARMs, in the biz) and you're worried that it's getting way too adjustable, don't worry: The Nanny State is about to readjust it well inside your comfort zone. By fiat of the Treasury secretary, your adjustable-rate mortgage is henceforth an unadjustable adjustable-rate mortgage. These new UNARMs will spread their healing balm across the land until it's safe enough for the housing "market" to once again be exposed to market forces.

The government has, in effect, nullified the terms of legal contracts mutually agreed by both parties – borrower and lender, Mr. and Mrs. Joe Schmoe and the First National Bank of Pleasantville.

This is a pretty remarkable act by a "conservative" administration. The government's general absolution for imprudence by both borrower and lender doesn't seem a smart move – for the U.S. credit markets, for real estate, for responsible borrowers for future homeowners, or for state and municipal taxpayers whose governments are being encouraged by Washington to bail out home "owners" by issuing tax-free debt.

Thus endeth the free market. A free market doesn't just involve consumers, but also producers, who need to earn a competitive profit in order to stay viable and continue to produce. Lenders sell ARMs with an eye to long-term profits by offering very thin margins for themselves on the front end. If they cannot adjust the rates of these ARMs on schedule when the price of money rises, then they lose the profit on which they have planned.

What does that do to the market? The producers -- lenders, in this case -- have to either raise prices or restrict production. In this market, it means that credit tightens and people who may have been able to get home loans will get rejected instead. ARMs will almost certainly decrease, if not disappear altogether. Some may find that appealing -- but it will exclude many potential homebuyers from entering the market. That will increase the downward pressure on home valuations, already a major problem in this economy.

A free market allows producers and consumers to treat each other as adults and rational actors. Contracts depend on this; it requires trust that all parties will act in concert according to the language. ARMs depend on this even more, as they necessarily adapt to changing conditions that cannot easily be predicted. Both parties in essence gamble that the changes in economic fortunes will benefit them in relation to the schedule of rate escalations, and that they will prosper a little more than in a normal fixed-rate mortgage.

By allowing the consumers to essentially welch on that gamble, the federal government has certified the consumers as children who could not act rationally on their own behalf. Lenders are rightly concerned about the protection of their risk as the Treasury puts its thumbs on the scales carefully engineered in the free market. When newspapers start filling with stories about how young couples and people who endured a few tough years can't get home loans, readers should recall how a supposedly free-market administration forced lenders to protect themselves.


TrackBack URL for this entry: