We began our quick analysis of President Bush’s loan modification plan yesterday by calling it a bailout. Today we hearing from all over that the plan is not a bailout. In fact, Felix Salmon has issued a public plea for everyone to stop calling it a bailout. And, more recently, he’s began recording a “bailout hall of shame” for those who have called this a bailout. This morning, Edmund Andrews emphatically insisted on the point in the New York Times. “At least one thing is clear about President Bush’s plan to help people trapped by the mortgage meltdown: it is an industry-led plan, not a government bailout,” Andrews wrote. And this afternoon the madness that is Jim Cramer unloosed itself on Erin Burnett to the same effect.
The main argument against calling this a government bailout is two-fold. First, it is said that the terms of the plan were set by the mortgage industry and Wall Street firms rather than bureaucrats. Second, it is stressed that the effort is voluntary on the part of lenders, borrowers and loan servicers. As comforting as it might be to consider this an outcome of market processes rather than government fiat, we’re not persuaded.
[More after the jump]
Let’s begin with the claim that the program is voluntary. The Wall Street Journal’s editorial board nicely demolished this argument yesterday. “Offering free advice is one thing. But when the feds sit down as a negotiating partner, the line between moral suasion and coercion starts to blur,” the Journal’s editorial pointed out. “Companies begin to think they're hearing an offer they can't refuse.”
It’s hard to underestimate the influence our government has over the home lending industry. From the Federal Reserve, to bank regulators, to civil rights enforcement, to the operations of Fannie Mae, the government’s role in home lending is pervasive. It would be quite difficult, not to say impossible, for a lender to resist a plan so publicly endorsed by the chairman of the Federal Reserve, the Secretary of the Treasury and the President of the United States.
What’s more, even if we ignore the way the government’s involvement in the banking industry blurs the line between moral suasion and coercion, calling the plan voluntary raises the question: who gets to volunteer? From our reading of the plan, the decisions to modify the loans will be made by loan servicers and borrowers. And although loan servicers have pre-existing rights to modify loans if it maximizes profits, they have heretofore been checked by the rights of investors. The plan circumvents these rights by establishing a new standard for the fiduciary duties of service providers, essentially insulating them from investor claims that offering the kind of refinancing and freeze options proposed in the plans are not likely to maximize revenue.
But if the plan limits investor rights, why do so many investors apparently support it? For instance, why has the American Securitization Forum endorsed it? Felix Salmon thinks that the reason is rather straight-forward: many investors expect to profit from modification since a performing mortgage with more borrower-friendly terms is likely to be worth more than a delinquent or foreclosed mortgage on the original terms.
Unfortunately, this does not mean that everyone stands to gain and certainly not everyone will gain equally. We're still working on the likely consequences (and by "still working" we mean sipping an espresso while Bess works out the different scenarios on Excel). The biggest gainers from this plan may be those investors who hold the riskiest tranches of debt—those least likely to be paid when mortgages run into trouble. Those holding the safer tranches of subprime backed paper (if you’ll pardon that somewhat oxymoronic string of words), however, may actually come to the opposite conclusion. Rather than maximizing profits, the modifications may lower their expected returns. Thanks to the Bush administrations plan, these investors may now find themselves without rights to prevent the modifications.
Now, we’re aware that there are some who think the plan might actually work in the opposite direction—helping the holders of senior tranches. You can read all about this point of view at Accrued Interest. Frankly, we haven’t had enough time to actually come to a firm conclusion of the winners and losers from the plan—and we’re not sure we ever will find such time giving that Friday happy hour is looming. (If you want a long analysis of the implications of the plan that diverges greatly from our own, check out Calculated Risk.) But the fact is that the identity of winners and losers among bond holders is irrelevant to our analysis. The point is that there is the potential that the plan will inflict damage on some security holders and unduly benefit others, while leaving them without recourse.
It is the contracts with investors that are being re-written by the government and collusion by loan servicers, (There we go ignoring yet another of Salmon's pleas.) Wall Street firms and certain segments of the investors. Without the government’s endorsement, this approach would be fraught with legal peril from the rights of dissenting investors. But with that endorsement it seems to essentially create a “safe harbor” provision for modification since the plan will now become the accepted industry practice. That’s a change driven not by a market-process or any actual custom of servicers but by government fiat.
The other point made by Andrews is that the program can’t be a government bailout because its terms were set by the industry and Wall Street. We’ll answer that by simply pointing out that if we were to stop considering programs whose terms are set by industry and Wall Street as government, we would have radically revised the definition of government to include very little of what the government actually does.
So we’ll gladly take our place in the so-called Hall of Shame for calling this bailout what it is.