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After The Fall: Saving Capitalism From Wall Street--and Washington

After The Fall: Saving Capitalism From Wall Street—and Washington

by Nicole Gelinas

Senator Uncertainty
McCain’s mortgage proposal contradicts the Paulson plan he just endorsed.
10 October 2008

Senator John McCain’s “American Homeownership Resurgence Plan” is a faulty idea on the merits, but the world is full of bad ideas. The grave problem with the McCain plan is that it directly contradicts another one that the senator very recently supported—the Henry Paulson-engineered, $700 billion bailout package, which Congress passed last week. McCain’s seemingly unconscious turnabout introduces yet more uncertainty into the debt markets. Ambiguous government flailing is the last thing that the doubt-frozen markets need right now.

Under his plan, a President McCain would “direct” his Treasury secretary to rescue homeowners who find themselves unable to pay their mortgages. Such mortgages include adjustable-rate loans as well as fixed-rate loans based on home values that have since deflated, precluding a refinancing to get a homeowner out of trouble. McCain’s Treasury secretary would buy up such mortgages from their private holders and servicers and replace them with fixed-rate loans based on lower property values so that homeowners could stay put.

Fair or not, some restructuring of home mortgages is inevitable under the bailout packages the feds have already passed. The government is likely to purchase at least tens of billions of dollars’ worth of mortgage securities under the $700 billion Paulson plan. As a big investor in these securities, it’s going to have to decide whether foreclosure or restructuring poses the least cost to the taxpayer on hundreds of thousands of loans. Out of a bunch of bad options, a loan workout, including a write-down of the value of the outstanding loan, sometimes can be the least-worst choice. Loan workouts are common enough in the private sector at the bottom of economic cycles. Here, in some cases, they often save the lender money compared with the alternative: mass foreclosures in a still-declining market. But the government and its asset managers were already going to face a tough time figuring out which mortgages are worth saving with a workout and which aren’t. McCain’s high-profile announcement makes that challenge even harder.

McCain says that he’d limit his offer to people who “cannot make payments” on their current loans; who live in the home whose loan they want restructured; who can show that they didn’t falsify their original loan application; and who put some kind of payment down when they purchased the house. It could be an administrative nightmare to figure out who can or can’t afford his current mortgage: two families earning the same income with the same mortgage may have different spending habits, pushing one into foreclosure but not the other. McCain’s declaration of a vast new government program, which could encourage many more people to try their luck, only complicates things further.

The strangest thing about McCain’s proposal, though, is that he doesn’t seem to realize that it directly contradicts his own previous backing of the Paulson bill—for which he suspended his campaign, jetted to Washington, and lobbied his own party.

McCain says that he would purchase the mortgage securities in question at face value, asking taxpayers, not financial institutions, to take the lumps on such securities. Under the Paulson plan, by contrast, the government will buy mortgage-backed securities from financial institutions, but not at face value. With discounts determined by auction prices, financial institutions will have to take losses. Similarly, under the Barney Frank-Christopher Dodd package passed last summer, the government could refinance a half million or so homeowners out of unaffordable mortgages and into fixed-rate, government-guaranteed loans, but only if the lenders agree to take up to a 15 percent loss on the original loan.

McCain’s idea imperils the Paulson plan’s already tenuous chances of success, because financial institutions might not sell their securities at what they see as low prices when they can hold out until after the election, and, in the event McCain wins, try to get 100 percent of those securities’ original value. The whole point of the Paulson plan was speed, but McCain has added a big speed bump. Further, the government’s attempt to set market prices for bad securities through its own purchases—a fool’s errand already—will be even more difficult if McCain wants to set those prices at 100 percent of value.

McCain further asserts that one reason to purchase bad mortgages at face value is to “support the value of mortgage-backed derivatives.” To my knowledge, McCain is the only candidate or Washington official to support such a goal. Yes, Paulson has said that he wants to find a market value for some such securities amid a market panic, which, he argues, has scared away buyers at any price, but that aim is different from explicitly supporting an inflated value. We have to sort through the derivatives mess, sooner rather than later, but McCain’s promise of government support for 100 percent of the value of some near-worthless derivatives gives their investors an incentive to continue to delay and obfuscate. (McCain wasn’t just being an inartful speaker; his campaign literature outlines the goal.)

Maybe McCain has changed his mind about Paulson’s original plan because the situation has deteriorated since he first offered his support. He may have offered to pay 100 percent of bad securities’ value because he realizes that many financial institutions cannot take their fair losses without being obliterated. The fear of such losses has increased their desperation for capital and increased potential investors’ refusal to provide it. Indeed, Paulson seems to be pushing his bad-asset purchases off a bit, instead planning quickly to inject public capital directly into private-sector banks in return for an ownership stake or preferred lenders’ rights, as Britain this week said it will do for its banks.

If he is reversing his position as the facts change, then McCain should say so. He might consider stating publicly that injecting capital into struggling financial institutions is far more honest than purposely overpaying for bad debt in an attempt to make it vanish. McCain claimed that one of his goals was to “eliminate uncertainty” and help unfreeze the credit markets. So far, though, he is just as likely accomplishing the opposite. Government intervention is warranted when the banking industry totters on the verge of collapse, but when proposed intervention comes in the form of contradictory signals from the same person within the span of two weeks, it isn’t helping.

Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst.

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