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Tuesday, January 8, 2008

Mortgage Bailout To Expand?

That appears to be the word from Treasury Secretary Paulson...
"One thing we will consider with the HOPE NOW alliance is ... maybe expanding this beyond subprime borrowers to other borrowers," Paulson said in the CNBC interview.

Paulson did not provide any details on when this expansion might go forward. The HOPE NOW alliance is a coalition of mortgage industry companies which are seeking to reach at-risk borrowers to help them avoid foreclosures.

The administration last month unveiled its most significant move to date to deal with the mortgage crisis when it brokered an agreement with the mortgage industry to freeze rates on certain subprime mortgages for five years in an effort to help homeowners in danger of losing their homes when their lower introductory rates reset to sharply higher levels in the coming two years.

...

Paulson in the CNBC interview also called on Congress to quickly pass pending legislation that would reform the Federal Housing Administration, which he said would help 250,000 at-risk homeowners who have adjustable rate subprime mortgages refinance to more affordable loans and another piece of legislation that would expand the availability of so-called "jumbo" mortgages, loans higher than $417,000.

The two giant government-sponsored mortgage companies, Fannie Mae and Freddie
Mac
, cannot presently back these jumbo loans, which restricts their availability.

A few things that I will note...I have already written why I believe the rate freeze for sub prime borrowers is a bad idea. it creates a moral hazard. It cannot be implemented in any practical manner, and it takes away profits from banks which will then be passed on to consumers.

Some of the same principles apply here as well however some things are different for prime. First, it is important to understand the debate within the industry. There are two factions as far as what caused the mess. The first faction, like me, believes that banks loosened up restrictions so much that irresponsible borrowers got loans and then didn't pay them back. The second faction sees it slightly differently. They see the proliferation of Adjustable Rate Mortgages as the culprit. They see folks getting into ARM's with the expectation of refinancing, and when that didn't happen, the mortgage crisis occurred. The second faction subsequently believes that the mortgage meltdown will reach prime because ARM's proliferated there as well.

Now, regardless of what is the reality, my faction or the other, the rate freeze is a bad idea. If I am right, ARM's adjusting shouldn't have a very large impact on prime borrowers, and thus the rate freeze is unnecessary. If I am right, then all that the rate freeze will do is take money off the table from banks. The banks will then pass that on to the consumer with higher rates and other fees. Second, prime borrowers are more sophisticated and wiser and many more of them chose fixed rates over ARM's. All of those folks will feel taken advantage of and lawsuits will be likely.

Even if I am wrong, the rate freeze is still a bad idea. First, no matter what the overwhelming majority of borrowers will still be able to make their payment on time. Thus, a wholesale rate freeze will affect a majority of loans however it will only be necessary for a minority. That means the banks will lose. Banks figured out rates for ARM's using a sophisticated method and one of the factors is the ability of said loan to adjust. If the government steps in and stops that, there are all sorts of unintended consequences. Banks have made projections and now the government is undercutting those projections. Sub prime is 35% of the market. Prime is the rest. Tinkering with the minority of the market is one thing, however when you artificially freeze rates on the bulk of the market now you are really dealing with forces beyond your control or understanding.

Freezing rates in such a wholesale manner as the one being proposed will likely create a credit crunch unlike anything we have seen.

Finally, just like with sub prime, there is the question of who gets their rate frozen and how will it be determined. If the government decides to freeze every rate on every ARM based on chronology that is crazy. If they use an ability to pay criteria, then my question is how will it be determined and who will decide.

The other point regards expanding the loan limits for prime beyond 417K. I have been in the business for six years. For the first four years, the limits expanded each year. The last two the limit has stayd at 417K. It is certainly not a coincidence that the expansion correlated with increased property values. Fannie and Freddie decide whether to expand and how much. The decision is solely their own. The decision is based on a sophisticated and complicated set of factors that no one, besides the powers at Fannie and Freddie, know or understand. For the government to once again take that decision away from Fannie and Freddie will also lead to unintended consequences.

Since each entity decides approvals through a complicated set of risk factors, opening the loan limits up will likely force the entities to make approvals more difficult in other ways. This decision will likely lead to less people being approved as all naive government decisions do in mortgages.

Even if my faction is wrong, and

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