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Deal To Save Borrowers, Lenders In Subprime Slide Has Fatal Flaws

December 03, 2007

By Nicole Gelinas

The Bush administration, federal regulators and big banks are "aggressively pursuing," in the words of Treasury Secretary Henry Paulson, a deal to save some mortgage borrowers and their lenders from facing the consequences of their bad decisions. The deal, called "Hope Now," could be called "Hope Now, Worry Later."

Part of the pact likely will call for lenders and "servicers" of mortgages, including tottering financial-services giant Citigroup and teetering mortgage giant Countrywide Financial, to change the terms of potentially north of a hundred billion dollars' worth of mortgages they approved for homebuyers over the past few years.

In these cases, borrowers, often those who couldn't afford high monthly mortgage payments or who didn't have much money for a down payment, took on debt that carried an initial "teaser" interest rate.

That is, instead of signing a mortgage that called for them to pay the same amount of money every month for 30 years, the borrowers agreed to pay a super-low rate for one or two years, and then pay a much higher rate for the remaining 28 years.

Investment banks then packaged and sold huge bundles of these mortgages to outside bond investors, so that the original lenders would have more money to make more such loans, and so forth.

For these deals to work after the "teaser" rates expired, the housing market could never falter. Why? Few borrowers could afford the new, higher rates they would have to pay in a couple of years.

Both the borrowers and the lenders knew this fact, or should have, but it didn't bother them. They assumed that when the "teaser" rate came close to expiration, the borrower could simply take out a new mortgage with the same "teaser" rate, providing new fees to mortgage lenders and brokers and buying himself more time.v

This scenario collapsed when the housing market started to decline, because a borrower can't refinance a mortgage loan if his home is worth less than the amount of money he already owes.

Since that fact became all too clear, the Bush administration and the markets have been terrified, because they know that nearly half a trillion dollars' worth of mortgages in these "adjustable-rate subprime mortgages" will "reset" over the rest of this year and all of next year, triggering the higher rates.

If a borrower can't pay the rate and refinance his loan, the normal procedure — and the terms of the agreement he signed with his lenders — calls for the lender's agent to take possession of the home, writing off the loss and selling the home to another buyer.

Paulson is devising a solution to this harsh reality. As he said Monday, "We will . . . ensure as many able homeowners as possible are reached and helped."

Part of his program, though, is akin to when economically illiterate governments fix prices to stop inflation, only this time, they're arbitrarily fixing rates.

Under Paulson's plan, the banks and investors will agree to keep those "teaser" mortgage rates in place, for several years, for borrowers who can afford their "teaser" rate but not their higher "reset" rate. (This deal won't cover all subprime borrowers, though, since many of them can't even afford their starter payments, as high default rates for mortgages approved in the past two years show.)

The flaws of the plan are many and fatal.

First, the deal will reward irrational behavior and encourage such behavior by homebuyers in the future. It was not logical for people to take out mortgage obligations they couldn't afford, but it will become logical for them to do so in the future if they can reasonably expect that the government and their lender will later bail them out when the going gets tough.

Second, the deal will thwart the market by keeping home prices artificially high. In recent years, laughably easy credit has let many people "buy" homes who otherwise could not have done so, pushing up prices.

We've had "liar" loans, in which people could just state their annual income without fear that their mortgage lender would call their employer to check. We've had "Nina" loans, for "No Income, No Assets." And we've had "Ninja" loans, for "No Income, No Job or Assets." Consumers, armed with the easy money provided by these silly terms, have pushed home prices to record levels when they're measured against personal income, making falling home prices not only inevitable but healthy.v

The deal, though, because it puts an artificial floor under home prices, thus will penalize a first-time buyer who didn't take out a mortgage he knew he couldn't afford, renting instead until prices fell enough for him to afford a home with a more conventional mortgage.

Third, the deal may hurt some borrowers it was meant to help, by encouraging homeowners who can barely afford their teaser rates to continue making those monthly payments in the hopes that the property market will recover quickly and they can sell their homes. If that doesn't happen, they'll be right back where they started in a few years.v

While it would cause them short-term pain, they'd likely be better off losing their houses and renting cheaper homes. They could then regroup, save money and rebuild their credit to buy an affordable property with a more conventional mortgage a few years down the road.

Fourth, the deal will allow investors in these mortgage securities as well as participants in the housing market to delay new pain, beyond what they've already experienced. America's economy is so successful, though, in part because of its efficient markets. Companies and investors periodically screw up, sometimes disastrously, but when they do, they have to take their punishment in the markets so that everyone can move on to the next big thing.

This deal would allow investors instead to push today's losses off to the future, implicitly assuming the housing market will resume its unsustainable rise and solve lenders' and borrowers' problems for them. It also discourages new investors, including potential homeowners, from diving into the housing market soon, helping the market to find its trough, because they'll know the feds have kicked the problem down the road.

It's similar to how Japanese government officials and regulators encouraged banks to keep bad loans on their books during that country's own economic malaise. This only prolonged Japan's stagnation.

Fifth, the deal essentially calls for banks and mortgage investors to rewrite billions of dollars in private investment contracts under government pressure. It's likely, for example, that banks that have been active in approving or underwriting subprime mortgages feel an implicit threat from the government as they negotiate.

As Paulson said Monday, "I expect all servicers will implement (the standards) quickly." Banks must wonder if there's a what-if to that sentence. One possibility is that both the feds and state attorneys general will go after them for supposedly using aggressive sales tactics with weak, vulnerable and often minority mortgage borrowers — unless they provide some extra-contractual relief to those borrowers now.

One must wonder whether investors in bank stocks as well as in mortgage securities wouldn't want to just foreclose, take their losses and get it over with instead.

Sixth, and most important, this mortgage mulligan will permanently alter investors' perception of the risk of government interference in the American credit markets.

Investors bought mortgage-backed securities because they thought they would be compensated for the risk they were taking in lending money to less-than-stellar borrowers. The investors expected to be compensated for this risk through the higher interest rate they expected in future years or from the extra fees borrowers would pay as they refinanced to escape those higher interest rates.

The willingness of a Republican president to endorse such mass-scale interference in the private markets doesn't bode well for future interest rates on all American consumer financing, including mortgages, because investors will see that the political risk is far greater than they had thought.

Original Source: http://www.ibdeditorials.com/IBDArticles.aspx?id=281573786489215

 

 
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