It’s pretty clear the quality of the loans diminishes if they are subject to rate co-opting (which is exactly what is happening here). Investors should hope that Standard & Poors does the right thing and follows through with their threat to downgrade such paper. It will serve two valuable purposes: state and local government funds will be precluded from investing, and everyone else can demand significant discounts to carry what can turn to junk whenever the political winds blow.

UPDATE: Nouriel Roubini has attempted to portray the positive aspects of the blanket bailout in what Paul Kedrosky called a “lucid” analysis. I’m inclined to categorize the take as a condescending, wholesale endorsement of socializing losses.

Roubini is correct on one major point – many investors will be better off under the bailout plan than they would in an equivalent case-by-case workout. The problem is, that is not the investors’ issue – the lenders and servicers would have born the brunt of workout costs, and investors would have no liquidated claim unless foreclosure proceedings began in the first place. It is those same lenders and servicers that agreed to a plan that essentially relieves them of their obligation – a plan which was crafted with little input from investors. In a court supervised workout, the syndicated debt holders possess substantial negotiating leverage. As far as I can see, those that had already passed on their risk and now faced extraordinary case-by-case workout costs did the decision making. You can use the excuse that the sheer size of the problem exacerbated this (lack of skilled workout professionals, etc) but the fact remains that obligations are being passed through to the ultimate rights-holder, and recent discussion in Congress may even further hamper debt owners’ ability to exercise due process in a court of law.

Further, in like-kind court administered matters, rarely is an arrangement reached which both reduces the value to creditors and keeps the value associated with lower classes (i.e. equity) fully intact. In this case, borrowers are getting a free ride and those that brought them into the deals are too – these two groups have already taken value off the table. Meanwhile, constituents which paid a premium for the perceived quality of mortgage-backed securities are being forced to accept whatever revised terms the government and its consortium dictate, and their downline investors, pensioners, and policy holders will ultimately be the ones who suffer.

Again, the concept of “better off” Nouriel Roubini describes may be correct in the theoretical case, but it most certainly isn’t equitable. The only way to make it so would be for lenders to provide fresh appraisals, and force borrowers to pass the potential upside between said appraisal and the value of the collateral at the end of the forbearance term to the mortgage-backed securities owners. How ridiculous would that be!

What should be done, however, is parse true “deadbeat” borrowers from those who either fell on tough times or were tactically outmatched by fast-talking mortgage brokers, not through costly analysis but through strict terms and conditions. Those terms should include freezing personal debt limits, prohibiting additional credit applications and/or extension of credit, and requiring the lending class (mortgage brokers/underwriters/originating lenders, etc.) to bear all costs of monitoring and administration.

As an aside, there is high likelihood that this reset program is going to do more harm than good. Above the amount that MBS investors initially lose from this deal, it sets an extremely high profile precedent for the future – rates are bound to go up for all classes of borrowers, if only for regulatory risk. Housing remains unaffordable for many, and a downright stupid investment for others – capital will remaining on the sidelines until prices adjust, which they must now do to an incrementally greater degree to compensate for increasing rates in an environment were median incomes are barely rising. It is going to be years before we truly understand what damage this dynamic may cause.

UPDATE 2: There is more insight into the deal over at Calculated Risk. Tanta concludes that the prospective loan modifications are within the bounds of the standard loan sale contracts, if only barely. Let’s see how long that lasts.

UPDATE 3: Bad economics indeed.

Of the 33 entities on the list, only three are classified as “investors.” In addition, you could easily exclude all of those – the American Securitization Forum is a trade association, not an investor (and is already included as such), and Fannie Mae and Freddie Mac are quasi-governmental agencies that, while they hold and/or “guarantee” a lot of mortgage loans, also derive a significant amount (if not the majority) of their income from packaging and selling debt to others. The majority of members are lenders or “mortgage market participants” – in other words, the folks whose faulty underwriting standards produced the mess in the first place. Then there’s the sprinkling of not-for-profits…I take it so the initiative has the appearance of “do-good-ness.”

Where the heck are the investors?

UPDATE: As Asia-Pacific credit risk grows as a result of the mortgage debacle…

Treasury Secretary Henry Paulson said yesterday he’s confident the government and banks will agree on a plan to fix some subprime mortgage rates before they reset higher and trigger a wave of defaults. A lack of information has created doubts about the proposal, analysts say.

When the people that actually own the mortgage debt aren’t invited to what is potentially the biggest forgive-and-forget party in the history of modern finance, I’d say that’s worthy of a few doubts.

UPDATE 2: Yves Smith notices the same problem.