Blunder Now Alliance

Story Highlights:

• The Feds and a consortium of lending institutions have generated the Hope Now Alliance to aid those with troubled subprime loans.
• Any way you look at it, this is bad policy and bad economics—lenders are exposing themselves to huge legal risks, and the practice of bailing out borrowers is antithetical to properly functioning capital markets.
• Luckily, the scope of the proposal is likely too small to dent stock returns or the economy significantly. But remain wary.

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One of the main risks to our bullishness is unnecessary regulation. Meddling governments have a penchant for impeding free commerce and generating all sorts of nasty unintended consequences. (Just look at what a mess the corn market is after Congress enacted ethanol subsidies.)

So our bullish hearts skipped a beat this morning upon reading headlines about a new federally led initiative to mitigate subprime mortgage foreclosures.

The Bush administration seems to be caving to pressure on the troubled subprime mortgage lending front. This week the Feds met with private financial institutions including now famous subprime toxic waste all-stars like Citigroup, Wells Fargo, Washington Mutual, and Countrywide. This federally led squad calls itself the Hope Now Alliance. Perhaps Blunder Now Alliance would be more apt.

The plan, designed to "reassure investors and limit subprime fallout," proposes to lock in ARM loans in danger of default for five to seven years. (Mind you, that destroys the whole "adjustable rate" part of the "adjustable rate mortgage" idea in the first place.)

The deal isn't official yet but looks poised to be enacted in some form. Under the proposal, loan institutions will extend, or "freeze," ARMs at the introductory rate for qualified individuals for as many as seven years. Eligibility to qualify for this "help" has not yet been determined, but talk seems to center upon three groups:

1. Those who can continue to pay interest even with a rate increase
2. Those who cannot continue to pay interest at the current rate
3. Those who would not be able to pay interest if rates increased

Rumor has it only the third group would be eligible to have its loans frozen. We hope that's the case. If so, that's a relatively small amount of mortgage debt—a few billion versus a US mortgage market of over $10 trillion—and likely wouldn't ding stocks or the economy much.

But here's where it gets murky and scary: The plan will not be enforced by the government. That is, the proposal won't become an actual law. Rather, the government will attempt to employ "moral suasion" to coerce lending institutions to comply. This move is either extremely dumb, or explosively brilliant—probably the former.

On the one hand, the government has worked out a situation where it doesn't have to actually create any new, permanent legislation while a very small contingent of the indebted get relief. That's really not too bad. On the other hand, coercing lender compliance to dictums that aren't actually laws exposes them to myriad legal troubles. Forcing banks to keep bad loans on their books is clearly not in shareholders' best interests, and lawyers love a good class action lawsuit. You can bet they'll be waiting with bated breath to pounce should these proposals go through.

Additionally, this Guardian Angel mentality only propagates trouble in the long term. Why even worry about the risks of default if you know Uncle Sam will bail you out anyway? Free markets should be allowed to determine who sinks and who swims. Future financial institutions will be more efficient, intelligent, and wary of risks in the long run if they're not constantly bailed out.

Call us crazy, but we like subprime loans. They enable folks to buy homes where otherwise they couldn't. Even if with higher default rates on the margin, overall, more folks are owning homes and are better off for it. Isn't that a great thing? We're willing to live with that, and so should the government.

The mere proposal of this bizarre plan shows us the perversity of most political solutions. Why is only one distressed group getting relief and not others? What is the logic behind any of it? The whole thing seems to be the result of politicking and negotiation—not what's best for the economy.

But we can breathe a sigh of relief for now. The Blunder Now Alliance seems too small to crush stocks. But be wary—this is the kind of thing that can wallop markets and economies if its scope becomes too large.

Have a great weekend.