Another Republican administration tries price controls

First, a bit of stage-setting:

Election Year Economic Policy, January 20, 2004

The clearest example of an election driven policy backfiring in subsequent years was Richard Nixon’s decision to impose wage and price controls. Richard Nixon assumed the presidency at the end of the go-go sixties, an era of tremendous technological advancements and a booming stock market. The stock market and economy started falling soon after he took over as president. By 1971 he was faced with unemployment of five percent and inflation of five percent, terrible numbers at the time. Nixon felt that a weak economy in 1960 had contributed to his defeat by John F. Kennedy, and he was worried that a troubled economy would cost him again in 1972. Looking for a way to juice the economy without increasing inflation, he settled on the idea of wage and price controls combined with government stimulus. This was a shocking proposal, as wage and price controls had last been used in the WWII era and Nixon had vehemently opposed them. Wage and price controls are generally considered to be a last resort economic policy, because they interfere with the function of the free market and typically create a huge spike in inflation when removed. Obviously, President Nixon believed that the success of his re-election drive in 1972 called for unusual measures.

Wage and price controls became law in August of 1971, one year before the election. The economy advanced in 1972 without an increase in inflation, the stock market gained 17 percent, and Nixon was re-elected in a landslide. By 1973-74 the economic wheels were coming off, the wage and price controls were relaxed, inflation accelerated, the economy went into a deep recession, and the stock market collapsed. While Nixon resigned over Watergate, the disastrous state of the economy in 1974 did not help his standing with the public. The mess created by the imposition of wage and price controls finally ended years later when Jimmy Carter lifted the remaining price controls on the critical oil and natural gas sectors.

The actions President Bush has taken to revive the economy have become more dramatic as the time to re-election has grown shorter. Accelerating future, scheduled tax cuts to the summer of 2003 was his boldest and most controversial attempt to kick the economy into high gear. This policy has caused an explosion in the federal budget deficit, a problematic situation that either he or a successor will grapple with after the election. From a political perspective tax reductions are always a winner. Any sort of tax reduction comes as welcome relief for the majority of Americans living check to check, or trying to save for some bigger ticket item. The possible negative effects of huge budget deficits are not easily quantifiable and are too far in the future to concern most people. There are strong constituencies in the country that support spending programs and tax reductions, but a distinct minority of fiscal conservatives in favor of balanced budgets.

The International Monetary Fund recently warned that U.S. budget and trade deficits pose a significant threat to the world economy in coming years. Robert Rubin and Paul O’Neil, former Secretaries of the Treasury, have expressed strong concerns that high deficits will lead to some combination of inflation, higher interest rates, tax increases, and the inability of government to meet its stated obligation to retirees. None of these unpleasant outcomes are likely to be apparent before Election Day in 2004. While voters may be focused on conditions in 2004, investors who expect to be holding either stocks or bonds for a year or more have to think about 2005 and beyond.

In recent years the U.S. economy has been stimulated by record low interest rates, substantial tax cuts, and a falling dollar. The question is whether economic growth can become self-sustaining in the absence of further stimulus.

Now this:

Rate Freeze Plan Pumps Lenders By Laurie Kulikowski

Shares of the big mortgage lenders surged on Friday on news that regulators and industry executives were meeting to flesh out a plan to temporarily freeze interest rate resets on certain subprime adjustable-rate mortgage loans.

Regulators and executives ... were close to agreeing on a plan that would extend the teaser rates on subprime mortgages that promoted low interest rates for the first two to three years, but then reset to much higher fixed rates for the majority of the life of the loan, The Wall Street Journal reported.

"The plan being floated by Treasury to temporarily freeze subprime mortgage rate resets makes compelling sense, in our opinion," Howard Shapiro, an analyst at Fox-Pitt, Kelton, writes in a note. "It is a necessary step to stabilize reeling mortgage markets and avoid a further downturn, as servicers struggle to cope with a cascade of current and potential foreclosures."

The WSJ story that broke this news added:

The Bush administration has been looking for ways to stem the fallout from the mortgage crisis. Treasury Secretary Henry Paulson and Housing and Urban Development Secretary Alphonso Jackson helped assemble the coalition so that government officials could have a single counterpart with which to discuss terms of a plan.

While the government can't force the industry to modify loans, Mr. Paulson and other administration officials have been using moral suasion to push for workouts, telling the companies it is in their interest to avoid foreclosure since most parties can lose money when that happens. A similar plan to freeze interest rates temporarily was recently announced by California Gov. Arnold Schwarzenegger and four major loan servicers, including Countrywide.

Mr. Paulson, who is philosophically opposed to federal meddling in markets, at first rejected a sweeping approach to loan modifications when the idea was floated by Federal Deposit Insurance Corp. Chairwoman Sheila Bair. But he shifted his position recently. He told The Wall Street Journal last week that it would be impossible to "process the number of workouts and modifications that are going to be necessary doing it just sort of one-off."

David Gaffen blogs in the WSJ MarketBeat,

Expect lots of talk of the moral hazard....

The questions that remain — and they’re valid points — are thus: will such a plan only postpone further doom for the borrowers who went after these loans willingly or were suckered into it? Kevin Funnell of the Bank Lawyer’s Blog addresses this, saying “how much water will leak out of that hole-filled container before the eventual day of reckoning finally arrives, three-to-seven years down the road?”

Meanwhile, will this encourage more predatory lending by those lenders knowing that if you screw with a handful of people, you’re in trouble, but if you screw with everybody (and all of your fellow financial firms do the same), you’re now “too big to fail?”

“If the plan is successful, look for it to be next applied to option adjustable rate (negative amortization) loans…and then in 2010, holders of Alt-A loans,” writes Tim Iacono on his “Mess That Greenspan Made” blog.

Another problematic aspect is this — investors were expecting higher interest rates to be paid to them when they bought these mortgages, and a blanket reworking of this might cause them to cry foul, writes Yves Smith in the Naked Capitalism blog. “It isn’t at all clear that the servicers can enter into loan modifications like this unless they will help, or at least not hurt, the investors,” he writes.

Or maybe, as so much of politics is now, this is largely a public-relations effort...

Calculated Risk is still looking for Moe.

Todd Harrison, at Minyanville, has this take:

“If only we could freeze the rates on loans to sub-prime borrowers,” he [Hank Paulson] must be thinking, “we could stem the surge in foreclosures and sidestep the coming storm of adjustable-rate mortgages.”

First and foremost, you can’t arbitrarily freeze select components of the market machination without affecting derivative markets. There are two sides to every trade and someone will be left holding the bag.

Details are still being ironed out, from what I understand, but I don’t foresee this going through without government subsidy. I have the same view regarding the proposed super-conduit rescue plan. We never heard particulars on who was providing the funds but I would lay odds that Mr. Paulson and his deep pockets are involved at some level.

This is yet another step towards the socialization of our markets. Mr. Practical and I had dinner last night as we spoke about what we both believe to be the most interesting juncture in financial history.

Yves Smith at Naked Capitalism says,

Paulson seems unable to learn from his own experience. He is swinging for the fences with another Big Scheme That (Purports To) Fix The Problem With A Master Stroke. His track record here is not encouraging.

Ironically, if the California plan and any state or federal programs along similar lines do help a lot of borrowers, they could run into a second set of problems: investor lawsuits. It isn't at all clear that the servicers can enter into loan modifications like this unless they will help, or at least not hurt, the investors. It's hard to establish that with blanket programs, which is what these are intended to be.

Even if the dreadfully named Hope Now Alliance comes up with a remedy for borrowers, don't assume it can't be contested as an illegal breaching of contractual rights.