Henry Paulson Strikes Deal to Prevent Re-Setting of Subprime Loans

Last week, Fed Chairman “Helicopter” Ben Bernanke hinted that investors might get a rate-cut stocking stuffer this month. This week, former Goldman Sachs (NYSE:GS) man and current US Treasury Secretary Henry “Mr. Freeze” Paulson may give the market the biggest gift of all: a perceived end to the subprime crisis.

Reuters reports that Paulson has brokered a deal between mortgage lenders and investors to prevent the re-setting of a wide swath of subprime loans. The plan would freeze the loans at their current rate for five to seven years so that the borrowers would have time to get their financial house in order and not lose their home.

Well, we were looking for a "deus ex machina" to the American mortgage crisis last week. But we admit we didn’t see this coming. Freezing the rates on re-setting sub primes seems like a huge challenge.

Both the borrowers and lenders are keen to agree. The lenders (the banks) don’t want to foreclose the possibility of any future payments from distressed borrowers (who could just mail in the keys and start over). The borrowers would presumably love an interest rate amnesty and the chance to recover from a bad financial decision. Wouldn’t we all like a second financial chance?

The sand in the gears may come from investors who bought securities based on those mortgages. Will those investors be paid? Will they be content with a smaller return as opposed to a complete loss? And how can investors even prove they are entitled to a piece of the rescheduled payments? Also, who will be eligible for amnesty and who will not?

Frankly, this looks like the kind of thing a young lawyer fresh out of law school could make a career on. There will be lots of litigation. That’s not to say doing nothing is preferred. Lenders are free to modify the terms of a mortgage if they’d like in order to prevent a total loss.

But the presumption in all this is that if the resetting wave of ARMs can be put off for five to seven years, the US housing market will recover. Inventories of unsold homes will eventually decline. Order will be restored to the credit market and disaster avoided for borrowers and lenders.

We’re not counting on it. But we did read an interesting article from Simon Hunt over at Mineweb.com that made sense. Hunt says that because 2008 is an election year, “We can be sure that the US authorities and others will produce a trick out of the bag which would temporarily shore up the system, but, in the process, make the crisis even deeper, when the final tsunami wave strikes (2009-2013).

“In effect,” he continues, “the authorities will inflate their way out of today's turmoil. Money will have to find a home: it will go into equities and commodities, thus creating the final fifth wave of this cycle, which by its nature tends to be parabolic in direction. 2008 should then be characterised by rising stock and commodity markets at least until mid-year. Once these markets have reached their peaks (latest spring 2009), a 4-5 year bear market will unfold, which will be characterised by the unwinding of a decade of leverage.”

Dan Denning
The Daily Reckoning Australia

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