In a shocking switch, banking giant Citigroup (NYSE:C) is now supporting a Senate bill that would enable bankruptcy judges to modify the rates and principal amounts of mortgage loans on first homes.

Note that, under the plan, homeowners don't even have to try to renegotiate the terms of their loan directly with their lender – they simply have to certify that they attempted to contact the lender prior to the start of bankruptcy proceedings.

A blow against contract law
If this bill were to become law, it would dangerously undermine contract law. Technically, it would apply only to existing mortgages, but what's to stop legislators from doing the same thing in any future housing slump? In order to protect themselves against this possibility, we should expect mortgage lenders to raise mortgage rates, which will only end up harming homebuyers.

Although the Treasury assured us that it would be a purely passive investor when it took significant stakes in leading banks, including Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), and Wells Fargo (NYSE:WFC), the evidence looks increasingly contradictory. Surely it's no coincidence that of the nine banks, Citi was the only subject of a two-step capital injection – the government's largest?

Misguided efforts built on a fantasy
This bill is a fine example of the fallacy that if we do everything we can (including subverting market mechanisms) to keep people in homes they can't afford, housing prices will stabilize and all will be well. It's a candy-coated fantasy -- the same sort of reasoning that contributed to the failure of Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE).

As Friedrich Hayek wrote in The Road to Serfdom, his classic appeal against creeping state meddling in economic affairs: "It may sound noble to say, 'Damn economics, let us build up a decent world' – but it is, in fact, merely irresponsible." In the current crisis, Hayek's warnings are a relevant as they were in 1944.

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Fool contributor Alex Dumortier, CFA has a beneficial interest in Wells Fargo, but not in any of the other companies mentioned in this article. JPMorgan Chase and Bank of America are Income Investor selections. The Motley Fool's disclosure policy, given a choice of Hayeks, would take Salma over Friedrich.