David Fiderer: The Simple Arithmetic of Hank Paulson's Financ...

Financial markets just gave Hank Paulson a vote of no confidence. Unfortunately, it's the rest of us who will pay the price. As Paulson made clear this past week, he is stalling, subverting the express intent of Congress when it passed the bailout bill, by his refusal to take action on foreclosure relief for distressed homeowners. Paulson's inaction has triggered a chain reaction that goes something like this:

First: Treasury says it won't take steps to prevent home foreclosures, so that
Second: Prices of mortgage securities collapse, so that
Third: Bank equity gets wiped out, so that
Fourth: Banks, with shrunken equity capital, are forced to cut back on all types of credit, so that
Fifth: Financing for anything, especially residential mortgage loans, dries up, so that
Sixth: Market values of homes decline further, so that
Seventh: Mortgage securities decline further, and the downward spiral becomes self perpetuating.

This phenomenon is best illustrated by the numbers.

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Why did mortgage securities and bank stocks fall so much more sharply in the last few weeks? The market was expecting that Hank Paulson would act in a manner consistent with Congressional intent when it passed the bailout. As time passed, anxiety about treasury's inaction increased. Then on November 12, Paulson announced that he would do nothing soon to provide foreclosure relief to homeowners.

As we've seen above, stabilizing home prices is key to stabilizing the broader economy. And the key to stabilizing home prices is to limit the spate of foreclosures that would flood the market. If homeowners are able to remain in their homes and make partial payments on their mortgages, lenders may attain a better recovery than from a series of fire sale liquidations.

The problem is concentrated among private-label securitizations. Though they represent only 20 percent of all mortgages, they represent 60 percent of all defaults, according to The Financial Times. Unlike most mortgage securities that follow the standardized underwriting guidelines of Fannie Mae and Freddie Mac, private-label securities make it almost impossible for the lender to negotiate modifications with the homeowner. Congress passed the bailout package on the condition that a large chunk of the $700 billion to assume control of these assets so that the government could renegotiate terms with distressed homeowners.

Paulson ignored Congressional intent, and went off into an entirely different direction, allocating funds to bolster securitization of credit card receivables. Barney Frank, with great specificity, called him on his bad faith bait-and-switch tactics. But that exchange didn't get nearly as much coverage amid Paulson's platitudinous soundbites and talk about bailing out GM.

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