Saturday, December 08, 2007

The Subprime Bailout

The City Journal magazine recently pointed out that the recent talks of a government bailout of subprime borrowers--a bailout that basically excuses and forgives the idiocy of people who rolled the dice on their future by taking out subprime mortgages--will be hazardous, not only to those who get bailed out, not only to the housing market, but also to those who were prudent and waited for the market to correct itself.


Henry Paulson’s Mortgage Mulligan
A new subprime debacle
Nicole Gelinas
3 December 2007

The Bush administration, federal regulators, and major investment banks are “aggressively pursuing,” in the words of treasury secretary Henry Paulson, a plan to save some mortgage borrowers and their lenders from the consequences of their bad decisions. The deal is called “Hope Now.” It should be subtitled: “Worry Later.”

Part of the pact likely will call for mortgage lenders and their agents—including teetering mortgage giant Countrywide Financial and tottering financial-services giant Citigroup—to change the terms of, potentially, more than $100 billion worth of mortgages that they approved for home buyers over the past few years. In those cases, borrowers, often those who couldn’t afford high monthly mortgage payments or who didn’t have much money for down payments, took on mortgages that carried initial “teaser” interest rates. That is, instead of signing mortgages that required the same monthly payment for 30 years, the borrowers agreed to pay a super-low rate for one or two years, and then to pay a much higher one for the remaining 28 or 29 years. Investment banks then packaged and sold huge bundles of these mortgages to outside bond investors, providing the original lenders with more money to make more such loans.

For these deals to work after the teaser rates expired, the housing market could never falter, because few borrowers could afford the new, higher rates that they would have to pay in a few years. Both the borrowers and the lenders understood this risk, or should have, but they ignored it. They assumed that when the teaser rate came close to expiration, the borrower could simply refinance his loan, taking out a new mortgage with a similar teaser rate—which would buy more time for the borrower and also provide new fees to mortgage lenders and brokers. 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.

Now the Bush administration and the markets are terrified, because they know that nearly half a trillion dollars’ worth of these “adjustable-rate, subprime mortgages” will “reset” over the next year, triggering the higher rates. If a borrower can’t pay the rate and can’t refinance his loan, the normal procedure—under the terms of the agreement that he signed with his lender—calls for the lender’s agent to take possession of the home, writing off the loss and selling the home to another buyer.

But Paulson is devising an escape from this harsh reality. Under his plan, banks and investors will agree to keep the teaser mortgage rates in place, likely for several years, for borrowers who can afford those rates but not the higher “reset” ones. (Hope Now won’t cover all struggling subprime borrowers, though, since many borrowers can’t even afford their starter payments, as high default rates for such mortgages approved in the past two years show.) Paulson’s program is somewhat analogous to the price fixing that economically illiterate governments do to stop inflation—only in this case, the government is fixing rates rather than prices.

The Paulson plan’s flaws are manifold—and fatal. First, it will reward and encourage irrational behavior by future home buyers. It wasn’t logical for people to take on mortgage obligations that they couldn’t afford, but it will become logical in the future if they can reasonably expect that the government and their lenders will 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 allowed many people to “buy” homes who otherwise couldn’t have. We’ve had “liar” loans, in which people could claim a false annual income without fear that their mortgage lenders would confirm the figure. We’ve had “Nina” loans (short 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 lenient arrangements, have pushed home prices to record levels as measured against personal income. The decline of home prices, then, was both inevitable and healthy. But Hope Now, by placing an artificial floor under home prices, will penalize first-time buyers who did the right thing: not taking out mortgages that they knew they couldn’t afford, but renting instead until prices fell and they could afford homes with more conventional mortgages.

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 hope that the property market will recover quickly and allow them to sell their homes. If that doesn’t happen, they’ll be right back where they started in a few years. 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.

There are three more points, but they're a little more esoteric. Read them here.

1 comment:

Moe said...

Welcome to my nightmare of finding qualified lending customers :)

This hasn't affected Washington state near as bad as other parts of the country. We still have relatively low foreclosure rates here.

The one thing I didn't agree with in this article was this statement: " will reward and encourage irrational behavior by future home buyers."

I agree it will reward some past irrational behavior, but I disagree it will encourage it in the future. The tightening of the mortgage industry is not a temporary thing and congress may enact more laws to force the tightening further. That will prevent most customers from being irrational even if they want to be. It will discourage them because they will continually get turned down every time they apply for an "irrational" mortgage.

Those with good credit, debt-to-income ratios, and loan-to-value ratios will have no problems being approved for loans at good rates, but the days of 100% financing with terrible credit on stated income is long gone.

And for real estate investors, the approvals are getting even tighter. Much of our current problem is due to speculation and borrowing on non-owner occupied properties.