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The Law vs. Paulson

Hank Paulson's subprime bailout plan destroys the basic rules of US contract law...

WHEN US Treasury Secretary
Henry Paulson looks at this chart, he probably tells himself that he must do something – anything – to help the housing market

   We look at this chart, however, and tell ourselves that the best thing the Treasury Secretary could do would be to do nothing at all.

   The chart depicts the value of asset-backed commercial paper (ABCP) outstanding. ABCP volumes are plummeting because most investors are terrified to lend to an asset-backed entity.

   "Commercial paper" – the "CP" in ABCP – refers to short-term corporate debt. Specifically, unsecured short-term promissory notes issued by corporations with maturities that typically range from 30 to 270 days. Asset-backed CP is that which is collateralized by an asset-backed entity – i.e. an entity that owns assets like mortgages or credit-card receivables.

Since most institutional investors realize that the prices of asset-backed securities are tumbling, most investors refuse to provide CP financing to these entities. And most investors will not resume providing financing to the AB market until they believe that their collateral is solid and accurately priced.

Private investors have withdrawn a staggering $354 billion of CP financing from asset-backed entities since August. Enter Hank Paulson.

Treasury Secretary Paulson wishes to freeze sub-prime mortgage rates for five years. Is anyone else wondering what I'm wondering?

Which constitutional amendment empowers the US Treasury Department to retroactively nullify and/or revise contracts between private parties?

And where did Treasury Secretary Paulson read that he possessed the power to alter the terms of mortgage contracts between banks and individuals?

Seems like Treasury might be overstepping its bounds a little.

Even if Paulson's Treasury did possess the power re-write mortgage contracts after the fact, why should it? What does this unprecedented meddling accomplish? The short answer is:

Nothing good.

But the meddling does accomplish a wide variety of bad things. It tarnishes (if not destroys) America's free-market reputation. It also undermines all of the implied guarantees that this reputation conveys – like the guarantee that the government won't fix prices in public markets, or change private contracts after the fact, or in any way expropriate assets or profits that freely operating markets would otherwise bestow.

Pauslon's plan replaces these reliable tenets of functioning capitalism with the expedient caprices of quasi-populism. In other words, Paulson's plan establishes a brand new precedent in American capitalism that goes something like this:

The ends justify the means, especially if the ends include safeguarding Wall Street's compensation structures.

The specifics of Paulson's "it's-not-a-bailout" bailout are as follows: Homeowners with adjustable rate mortgages (ARMs) originated between Jan. 1, 2005, and July 31, 2007 may be able to qualify for a five-year rate freeze at their present, lower payment rate.

Only borrowers who have been making payments regularly would qualify for the rescue. So Paulson's plan completely ignores the folks who have already lost their homes or are very likely to do so.

"These homeowners will likely become renters again," the Secretary blandly explains.

And rather than rescuing homeowners who are drowning in their debts, Paulson's plan offers a life raft to borrowers who are already afloat. The plan helps those who need help the least – borrowers "with steady incomes and relatively clean payment histories..."

Why the counter-intuitive obsession with healing the healthy? We offer a cynical guess: healthy borrowers make their payments. Healthy borrowers, as we pointed out in the December 4, 2007 edition of the Rude Awakening, "are the ones who currently provide the cash-flow to the mortgage-backed securities that burden the balance sheets of every Wall Street brokerage firm and every major financial institution in the land.

"If the cash-flow continues, the brokers and banks may avoid paying for their sins of stupidity and continue paying themselves obscenely large bonuses."

So why is Paulson's bailout such a bad idea? Mostly because it rewards irresponsibility, while simultaneously corrupting the American system of contract law. Specifically, the plan violates the contracts of investors in mortgage-backed securities, who may lose money as a result of the rate freezes.

In order to railroad this overtly non-legal rescue package into the mortgage market, the creators of the scheme perverted the concept of "industry standard practice".

If you don't understand this term, don't worry. Neither did I until my brother, a lawyer in a former life, explained it to me. Industry standard practice simply refers to the generally accepted way of doing something. Everyone bakes a pizza, for example. No one boils it.

"When securitizers purchase loans," a recent editorial in the Wall Street Journal relates, "the Pooling and Servicing Agreements normally assign [mortgage] servicers a fiduciary duty to maximize cash-flows for the investors. In some cases, servicers can modify loan terms if this is consistent with 'standard industry practice.' [Now Paulson's] plan establishes a new 'standard industry practice'."

The problem is that retroactively freezing teaser rates for a 5-year term bears no resemblance to any 'standard industry practice' that has ever existed in the American mortgage market. So it's a very large stretch for Paulson & Co. to make such an assertion.

Not content to simply pervert this aspect of contract law, the Bush administration also seeks to reinforce its legally indefensible position by passing laws to immunize all financial institutions that implement the rate freeze from shareholder lawsuits.

"Mortgage investors are likely to challenge any re-writing of their contracts," writes blogger Juan Carlos Arroyo Calderon at "If the Supreme Court still honors 'stare decisis' principles, it will recognize that contract law goes all the way back to medieval England. If the government can void and rewrite legal contracts based on pure expediency, we might as well burn the Constitution."

"Stare decisis," Wikipedia explains, "is a Latin legal express the notion that prior court decisions must be recognized as precedents, according to case law...The term is but an abbreviation of 'stare decisis et non quieta movere' – 'to stand by and adhere to decisions and not disturb what is settled'. Under the doctrine of stare decisis a case is important only for what it decides – for the 'what', not for the 'why', and not for the 'how'."

   Legal precedent is not optional in a first-world economy. Case law is not a buffet from which Presidents and Treasury Secretaries may pick and chose according to the socio-economic whims of the day. The principal of "stare decisis" is the immutable foundation of any viable economy. If Treasury wishes to alter the structure of mortgage contracts, it ought to bring a test case before the Supreme Court.

   Otherwise, obey the law as written.

   Why? Because that's how financial markets thrive. They thrive by nurturing reliable, legally defensible agreements between private parties. Not by concocting perversions of free market practices. They thrive by allowing bad investments to fail...and good investments to flourish.

   Paulson's meddling accomplishes the exact opposite. It also produces a host of other economic evils.

  1. Produces government-sponsored capital losses for the holders of mortgage-backed securities;
  2. Artificially supports home prices;
  3. Tightens available credit for new, good loans but compelling lenders to retain old, bad loans.

If a government agency, in collusion with the Executive Branch of government, can simply dispense with legal precedent, it can also dispense with any other essential component of the American economic system. Capricious governments do not instill investor confidence.

   "If investors all of a sudden feel that a contract can be changed at the whim of industry participants or at the jawboning of government," Joshua Rosner of Graham Fisher & Co. explains to Bloomberg News, "ultimately that could have the effect of cutting off capital."

   In short, Paulson's plan is a bad, bad idea.

   As long as we are re-setting mortgages, why not re-set other inconvenient contracts? I've got a few January put options that aren't going my way. So how about extending my options out to, say, 2013 – only a year longer than Paulson's teaser-freezer? Otherwise I might lose some money. And if I lose money, I might not make my car payment. That might hurt the economy, no?

   In fact, why impose any limits on ANY contractual agreements? Maybe the government should boost interest rates on all existing bank CDs to 100%, and freeze that rate for five years. Or how about outlawing foreclosure? Or maybe even outlawing bankruptcy? And while we're at it, let's guarantee that every American make $200,000 per year.

   CNBC's jubilation notwithstanding, Paulson's bailout plan is so seriously flawed that it will not likely materialize as drafted. But if it does materialize and proceed, confidence in America's free-market economy will suffer a serious setback. To the extent that Paulson's plan succeeds, therefore, America fails.

   If the government wishes to bailout bankrupt borrowers, so be it. Bail away. But do so in a way that respects the sanctity of contract law and preserves the integrity of the American legal system. Very few countries re-write their laws after the fact. Those that do tend to lay close to the equator and elect people named Chavez and Morales.

   Is America going the way of her populist South American neighbors? Is she embracing the familiar policies of economic failure? Is she abandoning the foundations of her world-leading success?

   Just wondering.

Eric J.Fry has been a specialist in international equities since the early 1980s. A professional portfolio manager for more than 10 years, he wrote the first comprehensive guide to American Depositary Receipts, International Investing with ADRs. Today he reports on Wall Street from California for the renowned Daily Reckoning email service.

See full archive of Eric Fry articles

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