Congressional aides say the Bush administration has hammered out an agreement with industry to freeze interest rates for certain subprime mortgages for five years in an effort to combat a soaring tide of foreclosures.
These aides, who spoke on condition of anonymity because the details have not yet been released, said the five-year moratorium represented a compromise between desires by banking regulators for a longer time frame of as much as seven years and industry arguments that the freeze should only last one to two years.
Another person familiar with the matter said the rate-freeze plan would apply to borrowers with loans made at the start of 2005 through July 30 of this year with rates that are scheduled to rise between Jan. 1, 2008, and July 31, 2010.
This is a dangerous and bad policy on several levels.1)Whenever the government steps in on a private contract and renegotiates it, it leads to all sorts of unintended consequences. In this case, banks use extremely sophisticated modeling techniques to determine the interest rate that borrowers receive. Those models take into account whether or not a rate will eventually begin to move or not. By freezing rates for five years, he has thrown those models totally out of whack. In other words, the risk profile of these loans no longer matches the rate as determined by the models. This not only throws banks out of whack but Wall Street as well that turned those mortgages into bonds.
Whatever liquidity problems are currently in the market, those are nothing like the liquidity problems that will be created when loan terms are changed wholesale. If banks don't receive the rate, and the underlying payment, that they expected, then we will really see some liquidity issues. Remember, one, banks expect to take homes when payments aren't made, and two, they expected certain interest rates and payments from mortgages. Now, they will get neither, and their money is tied up expecting both.
This nightmare is further perpetuated because the definition of sub prime is not clearly defined. For instance, one of the big problem mortgages are option arms. Many of these mortgages are what we refer to as monthly ARM's. That means their rate changes every single month. If Bush includes these into sub prime, he will simply create a nightmare for the banks. Since they are monthly ARM's you can bet that much of the underlying rate was based on a model that had that rate moving every month. If that rate is now frozen for five years, you can bet that banks will take a giant financial hit.Keep in mind that if you don't care if banks take a hit, you should. If they take a hit, they will pass that hit onto the consumer in terms of higher rates on all future mortgages.
2) Bush has now also created a moral hazard. The folks that he is saving took on a mortgage profile, a rate that adjusts, that they shouldn't have. This was entirely by choice. Now, he is stepping in and stopping an event that is supposed to happen to an Adjustable Rate Mortgage. Instead of learning a difficult and valuable lesson, these folks will now get the message that risky financial moves can be met with government interference to save them before those risky moves turn into consequence.
3)Bush has now created a litigation nightmare. There are all sorts of folks that are currently in fixed rates, five year Arms, and other loans in which their rate either doesn't adjust or hasn't yet adjusted. Those folks are holding onto mortgages with higher rates than the folks who's rates he has artificially frozen. They will all scream bloody murder and demand that their rates be adjusted downward. They will be right. Imagine if you took on a fixed rate which was a higher rate than the equivalent adjustable rate. You did this with a certain financial loss, at least initially, because that rate was higher and with it the payment. Now, you hear that folks that didn't take the same precautions as you are now having their rates frozen for them artificially and will now enjoy lower rates, artificially again, for at least five more years. You would, rightfully so, feel entitled to the exact same rate. You would likely get a lawyer and I firmly believe that Bush has now opened banks up to all sorts of lawsuits.
4)Finally, and this is coming from an insider. This rate freeze isn't going to do anything of substance. The people that Bush thinks he is helping are in over their heads. I know because 99 times out of a 100 my borrowers always bought a property that was more expensive than one they claimed they wanted to buy. The sort of sub prime borrowers that Bush thinks he is helping are irresponsible. They bought 250,000 dollar homes when they could only afford 200,000 homes.
That dynamic is not going to be changed by freezing rates. These folks maybe able to afford to make these payments for a while longer but not forever. They are still in over their heads. Also, what about all of those folks that are in Prime loans that are adjustable rates. Won't they also demand that their rates be frozen? Won't everyone who is on time demand that their rate either be frozen or lowered? By helping the most desperate and the most irresponsible, Bush has now opened up a can of worms that he frankly can neither predict or control.
EPILOGUE:Now, a mortgage colleague of mine tells me that a radio report says that the only loans that will be affected will be those that are according to him, "on time". On time is rather nebulous. For instance, on time could mean current. It could also mean always on time. If he is only helping those that are always on time, then he is frankly taking all sorts of profit potential away from banks, because those folks most likely would have continued to be on time with or without the freeze. If he is talking about those that are on time now, but have been late, then he is delaying the inevitable. Either way, if it isn't defined clearly, I can assure all that it will be another litigation nightmare.