Just What We Need

Investors relaxed as media reports of a government bail-out plan for subprime mortgage holders seemed to be taking shape. The idea is to freeze interest rates for homeowners whose mortgages are scheduled to balloon to higher rates that would push them into default. We are wary that any such plan will ever see the light of day, and that it will have the desired effect even if it reaches fruition.

The first problem is that the troubled mortgages have been sliced and diced into a plethora of derivative securities owned by many different parties who may have wildly different goals. The legal and practical complexities of implementing a bail-out plan cannot be overstated. Think about all those papers you signed when buying your home, then multiply it by several million and you will get the idea. Second and perhaps more important, it is far from clear that freezing mortgage rates for some borrowers will solve their problems. It may just delay the inevitable. Lenders have been selectively doing this sort of thing for a long time, and reports show that the borrowers often end up defaulting anyway in another year or two. The best solution will almost certainly be to let nature run its course. As people default, more homes go up for sale and prices fall, the economy will naturally restore the balance that was lost over the last few years. The pain this will cause for many people is sad but there really are no better options.

The stock market is less concerned about borrowers and more concerned about the losses faced by banks and other lenders. Investors seem to welcome the bail-out talk since financial stocks are up sharply the last few days. Here again, we are concerned that the optimism is misplaced. Intermediate-term momentum still favors the economically defensive sectors like utilities, consumer staples and health care.