The Fallacy of Rate Tinkering

Here is the profile of the typical borrower that I believe is most in need of help at this moment. They bought a property for say $250K when really they probably shouldn't have gone over 225K. They likely got an ARM, and even an interest only, to make the loan work, however because they overbought their payment was frankly too high no matter what type of loan they got. Because it was, they likely robbed Peter to pay Paul so to speak for a while. What I mean by this is that in order to get money to afford their mortgage they ran up credit cards, personal loans, and any other form of cash they could get their hands on. Once they were tapped out they went back to their mortgage broker for help. Their mortgage broker could help because by this point their property had gained 10-15- and even 20%. Their mortgage broker wrapped up all their new debt and got them a loan at 275-300K. Now, keep in mind these borrowers couldn't afford their loan at 250k. They really couldn't afford their loan at 275k. I believe that for many borrowers this process happened multiple times and each time they gradually dug an even bigger hole for themselves. This means folks owe 30-50% and even more than they can reasonable afford on their loan amounts.

At this point, the situation is critical because all of this so called new found equity was a slight of hand of an out of control market. The values of their properties are now back at or even below their original cost. Meanwhile they owe 10-15-20 and even more percent more than their original cost. These folks are in big trouble.

Now, there all sorts of politicians offering all sorts of bailouts for these folks. In my opinion, none of them will work because what these folks need is relief on their loan amounts. In order to save these folks they need to owe what they can afford. This has less to do with the rate and much more to do with the loan amount. I am surprised a politician hasn't suggested that we en masse cut the loan amounts on all these borrowers by up to 30%. If we did, these folks would be saved. (While there are all sorts of dramatic problems with this the folks would get a payment they could afford and thus it could work politically)

On some level, I can't figure it out because cutting the loan amounts dramatically is no less extreme than cutting the interest rates dramatically or freezing them. Changing loan amounts on a private contract en masse is to me no different than changing interest rates on a private contract en masse. On a typical thirty year loan, the bank receives up to three times the original loan amount in payments over the life of the loan. In other words, the borrower winds up paying about 750k worth of monthly payments over thirty years on a 250k mortgage. Thus, a bank would still make plenty over the life of the loan even at reduced loan amounts.

Of course, there is one catch. Borrowers almost never hold onto a loan for the full term. Thus, a bank might loan 250k, and would get paid off significantly less than that a few years later (once those loans are invariably paid off by selling or by refinancing. If the loan amounts were reduced these two options that aren't available would suddenly be available) if those loan amounts were reduced en masse. Maybe just maybe, that is why the feds haven't suggested that loan amounts be lowered en masse.

Of course, there is an equally problematic reality with lowering rates en masse. Banks rarely hold onto loans for the full term of the loan either. Banks by and sell loans to and from each other all the time. By lowering or freezing rates on loans en masse the government is equally reducing the value of the loan from the perspective of the bank. By freezing or cutting rates, the government has just made loans less valuable to banks. Thus, a bank may get the shaft by buying a loan expecting one set of terms and getting another, or a bank could find that they hold onto a loan they can no longer sell because the terms have been changed. Either way, by freezing or cutting rates, the government disrupts the market for mortgages dramatically.

The difference between the two scenarios is that one is pretty obvious to most and the other is only obvious to professionals in the business. Neither of course makes any sense, but one's lack of sense is more subtle. Lowering rates or freezing rates en masse puts no less stress on the banks that are holding those loans than the stress that would be put on them if the government forced banks to reduce loan amounts en masse. The only difference is that lowering loan amounts enough would actually save the borrower. Of course, it would save the borrower at the expense of a total meltdown in the mortgage market.

The current rate freeze proposals would only disrupt the mortgage market even further and likely wouldn't destroy it. Of course, the current rate freeze wouldn't actually save the borrowers either. The fallacy of course is that the government is trying to save irresponsible people. That is the rub. The government would never refer to the folks as irresponsible but that is what they are. Anyone that needs the government to step in and reorganize the terms of a private contract so that they can meet the terms of that contract IS IRRESPONSIBLE.

That, ultimately, is the diciest part of this rate freeze. The government wants to rearrange the so called deck chairs on the Titanic. These folks are irresponsible. No government bailout will change that. They can freeze all the rates they want but the profile of the borrower won't change. Even if the terms were ultimately ones they could afford, it is likely they would use that opportunity to run up their debts. That likely won't happen anyway because these folks are irresponsible. Thus, they put themselves into a position that is beyond help.

The fallacy of the rate freeze is that it likely won't have much of an effect. Even if it did, those folks would likely use that opportunity to get into more trouble. If someone needs an en masse loan decrease, is that really the sort of person the government should try saving? That, ultimately, is the fallacy of the rate freeze. While there is no political advantage to doing the sensible, the sensible thing is to make these people suffer because while it isn't much of an option it is still better than anything artificial.