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Thursday, December 06, 2007


more on the paulson rate freeze

UPDATE: so useful it goes at the head of the post -- thank you calculated risk.

the idea of a rate freeze began in california and was quickly followed by a national plan backed by the treasury. on the whole, it is seen by many as prelude to an industry bailout and many others as doomed to fail. but at least some details are starting to emerge. per bloomberg:

Federal regulators and U.S. lenders agreed to freeze interest rates on subprime mortgages for five years to stem rising foreclosures, said a person familiar with the measure.

The freeze may apply to mortgages issued between January 2005 and July 2007 that are scheduled to reset between January 2008 and July 2010, said a person familiar with the plan. Borrowers whose credit scores are below 660 out of a possible 850 and haven't risen by 10 percent since the loan was sold will be given priority.

Those with scores above 660 will be more closely scrutinized to determine whether they are eligible or must continue making payments under existing terms, said the person. Most U.S. banks use FICO credit scores, a product of Minneapolis-based Fair Isaac Corp., to judge a borrower's ability to repay loans. Scores determine the interest rate charged to a customer.

tanta at calcluated risk quickly divined the meaning of this definition of "subprime":

Saying that efforts will be "prioritized" by FICOs under 660 is a way to try to target this effort to what we would consider "subprime," regardless of how the loans might be described by a servicer or in a prospectus.

And that, really, is a way to target the "freeze" to start rates that are already pretty high. I think some people are getting a bit misled by the idea of "teaser" rates here. As Bloomberg reports quite correctly, the loans being targeted have a start rate in the 7.00% to 8.00% range. (My back-of-the-envelope calculation is a weighted average of about 7.70%, with a weighted average first adjustment rate of just over 10.00%.) Nobody wants to come out and say that "Hope Now" is all about freezing just the highest initial ARM rates that there are, but that's in fact what it's about.

So asking, in essence, why we are "rewarding" people with the worst credit profiles is, really, missing the point. The point is that the cost of this goes directly to investors in asset-backed securities, and those investors are being asked to forgo 10% (the reset rate) and take 7.70% (the current or start rate). They are not being asked, say, to forgo 7.70% and take 5.70%, which is roughly what it would be if this "freeze" were extended to the significantly-over-660 crowd (Alt-A and prime ARMs).

So far, I'm prepared to believe assurances that this will not involve taxpayer subsidies: the cost of this is, actually, going to be absorbed by investors in mortgage-backed securities. This is why "good credit" borrowers are not going to be "rewarded" -- because investors cannot be brought to forgo that much interest. Somebody did the math, and somebody concluded that freezing a rate that is still about 200-250 bps over the 6-month LIBOR isn't going to be a disaster (at least not compared to having to foreclose these things).

so folks with higher credit scores are essentially ineligible, largely because investors aren't that desperate yet.

as we have recently come to understand, even many "subprime" borrowers in fact have decent credit but also bought too much house and carry a too-high-for-prime loan-to-value ratio. these people won't be aided, even though they exemplify the nature of the problem. what is happening is just not much to do with low-credit-score borrowers -- that's a fallacy that confirms many middle-class prejudices but does not model reality. the problem is here:

The fact is that huge numbers of people who have “prime” mortgage loans couldn’t refi or sell right now to—literally, for some of the uninsured—save their lives. They may well still be making payments on the mortgage, but they’re rapidly approaching upside-down if they’re not there yet, they’ve spent the proceeds of the previous cash-outs that kept up the lifestyle or just kept life together, and if the truth were known about credit card balances, their current FICOs probably aren’t the envy of the neighborhood either. They are, in short, subprime. They just don’t recognize themselves in the stereotype of the deadbeat serial bankruptcy filer or the undocumented immigrant or the waitress in the McMansion or whatever extreme case you can dredge up and label “typical” for subprime. They are, increasingly, “us.”

and that touches on the other lethal qualifier for the plan, as pointed out by mish:

Loan to value must be less than 97%.

in other words, if you're upside-down in your mortgage, you're not eligible. chances are if you bought a house in 2005, 2006 or 2007 with 5% down or less, you're upside-down thanks to nationwide price declines. if you're in florida or california -- the epicenters of the housing bubble -- chances are good that you're upside-down even if you put 20% in. but of course no one did, particularly in those states at those times, particularly if their FICO score was under 660.
UPDATE: with this followup, mish clarifies that in fact (and more sensibly) it's the other way around -- LTVs of greater than 97% are eligible.

and there is further this trenchant point via housing wire, as to what the big-picture effect of the rate freeze is as proposed, what might be coming, and what one can expect with regards to mortgage availability going forward.

There is, first of all, clearly the “so what?” factor. After all of this analysis, we’re still talking about a pretty small population of borrowers, in my opinion. Certainly not enough to stem the tide; after all, this is no longer about subprime resets. The problems we’re seeing are driven moreso by lost equity, high leverage, and borrowers finding themselves upside down even if their payments aren’t resetting.

Something tells me that if all this effort entailed helping just some small segment of borrowers, the ASF would not be working in lock-step with Wall Street to develop and implement standard criteria for reporting loan modification activity.

Does that make this effort a blueprint for future efforts, then? If so, borrowers had better pray they’ve got a conforming loan — because there won’t be much in the way of liquidity elsewhere if investors are sent such a message.

so it's understood -- the rate freeze as proposed helps too few people to make a dent in the problems, with newsday reporting estimates on the order of just 10% of subprime borrowers; helps some people who may represent appropriate objects of pity but who are not the typical cases of this crisis; and if it is expanded to help the people who do exemplify the problem in large numbers, mortgage investors will in all likelihood completely evacuate the field for anything but prime conforming which can be marketed to fannie mae and freddie mac. moreover, it is easy to see the incentive offered to many on the verge to destroy their credit scores in an effort to qualify for relief -- once again, responsibility being punished.

UPDATE: to the point raised by bill fleckenstein, tanta again:

From what I have seen about the plan to date, it is clear to me that it is in fact structured with the overarching goal of making sure that it stays on the allowable side of the existing contracts. I proceed from the assumption that nobody could write such a convoluted and counter-intuitive plan if that wasn’t the goal. So everyone who is thinking, “Gee, we’re violating contracts and we still don’t get much out of it!” is thinking the wrong thing, in my view. It’s more like “Gee, we don’t get much out of it when we don’t violate contracts.”

... [I]t’s not that we’re necessarily replacing the old-fashioned case-by-case mods with the fast-track “freeze” mods. We’re creating a way of segmenting the borrower class so that one class of borrowers can be presumed to meet all the requirements in the PSAs for modifications.

so the mechanics of the proposal are really to standardize who can have their loan modified without violating existing contracts or disqualifying certain tax elections in participating loan pools (that is in effect, default must be reasonably foreseeable -- among other things, the borrower is unable to refinance), as well as meet credit score and reset payment increase tests. but the existing contracts are fairly carefully designed to protect investors from the actions of servicers, not get them to take large loss burdens. and that fact in effect blocks this proposal as a real avenue to widesread help.

as is, then, this measure will very likely do little or nothing to even mitigate the credit unwind in housing, much less "stop" or "solve" it. as i said previously, it's even probable that many homeowners who qualify for a rate freeze will mail their keys to their mortgage servicer anyway, once they realize that they are not making headway on principal even as the price of the asset continues to fall away. (this is not, after all, real debt forgivenesss but the mere delaying of rate resets.) but we'll have to wait and see if an expansion of the program comes to light later on, as it appears the groundwork of such a thing might be being laid.

but the plan's greatest potential adverse effect, it seems to me, is precisely that possibility of future wholesale expansion upon the investors who would being asked (perhaps forced, before any bailout materializes) to forego income that they purchased in buying these loans and take the corresponding writedown. who cares about big-money investors? well, let's put names to them: citigroup, ubs, bank of america, bear stearns, fannie mae, freddie mac -- and virtually every insurance company, pension fund or endowment in the western world. the very spine of the united states, in many ways.

these entities are already awash in losses and desperately seeking capital. both freddie mac and fannie mae have slashed dividends and started issuing preferred shares paying punitive rates to raise cash.

now the plan could be to kick them again?

to be sure, the plan as it is is written by investors as much as anyone and represents no real threat to them (and therefore very little real relief to mortgagees). indeed, as one commenter at calculated risk noted, "it's already clear this has nothing to do with helping out borrowers for their sake, no matter what Bush and Paulson say -- it's entirely about minimising the damage to the securitisation industry and arguably to the wider economy." the plan keep people in their homes, playing on whatever sentimental attachment they have to the place to keep them paying on mortgages that they have little realistic hope of getting out from under. but with an eye forward to expanding the plan into meaningful debt relief, one has to be very wary of the unintended consequences. mark thoma channels the wall street journal and points out the essence of the issue:

This helps to highlight that while the Bush/Paulson plan to freeze the interest rate on some subprime loans may help some homeowners, subprime loan defaults are not the primary problem for the economy. The main worry is that banks and other lenders will pull back on loans of all type and cause a slowdown of investment and economic activity.

keeping the credit unwind orderly is job one, not saving some millions of american mortgagees who stupidly believed that something too good to be true wasn't. that's going to be hard enough to do, frankly, without adding to the misery of pressured capital. paulson's extant proposal, though it does little to really aid the beseiged masses, doesn't. learning the lessons of easy credit will be painful for those would-be homeowners; but pushing major financial institutions toward failure in an effort to engage in election-year populism could be vastly more so -- not just for them, but for all of us.

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