It is not quite right to describe the new White House plan as a bailout of subprime mortgage borrowers. Actually, it is a bailout for a tiny fraction of those with adjustable-rate mortgages (ARMs), not subprime loans per se. Nearly half of all subprime mortgage rates are fixed-rate loans, and only 32% of ARMs are subprime. With all the misplaced political anxiety about rates being reset, you might imagine that all those victims who signed-up for these mortgages had no idea their rates might actually be adjusted.
The Bush administration claims the plan will help "up to" 1.2 million people. Most of that promised help consists of nothing more than another phone number to call for counseling about refinancing -- a redundant service unlikely to prove wildly popular. Refinancing has been soaring anyway, thanks to 30-year mortgage rates dipping below 6%.
If risky subprime borrowers were actually supposed to be the main beneficiaries of such refinancing assistance, then it would have been the height of irresponsibility for President Bush to suggest greater involvement of the Federal Housing Administration, Fannie Mae and Freddie Mac. Shifting default risk to U.S. taxpayers could be very costly.
In reality, the only financial aid in this plan goes to those who qualify for the five-year freeze on mortgage rates -- a curiously selective little group, estimated to number between 145,000 and 360,000.
When it comes to resetting mortgage payments below the level borrowers agreed to, why give a special deal to Sam but not Suzie? On the day the plan was unveiled, the Mortgage Bankers Association reported that 0.78% of mortgages went into foreclosure in the third quarter, and that 5.59% were far behind in their payments. Neither group qualifies for any help under the Bush plan. Neither does anyone with imperfect timing -- those who took out a mortgage before 2005 or after this July. Among the few lucky enough to slip through that narrow window, the primary criterion for a rate freeze is a weak credit rating, below 660. And what happens after five years? Presidential contender Sen. Hillary Clinton is already talking about stretching it to seven years, and that bidding war has just begun.
On the face of it, these criteria for political favoritism seem only marginally more sensible than limiting special loan terms to, say, short people or redheads.
Is it a bailout? The stock market sure thought so. Stock prices of mortgage companies and homebuilders soared on the news. After all, the plan was designed by and for those same companies -- key members of the "Hope Now Alliance."
Treasury Secretary Hank Paulson describes the arbitrary rewriting of financial contracts as a win-win situation for everyone. If that were true, the government would not have to get involved. In a win-win deal, Sen. Clinton would also not have felt compelled to threaten legislation to prohibit lawsuits from unhappy owners of mortgage-backed securities. If this "changing of the rules in the middle of the game," as many have described it, becomes a precedent, future funding will dry up quickly and permanently -- particularly for low-income borrowers. Why buy a bond that can have its terms changed by political whim?
President Bush says he only wants to bail out borrowers, not lenders. Yet the whole point of this scheme is to cajole or bribe more borrowers into making more mortgage payments -- to lenders. The plan supposedly excludes speculators, because it applies only to owner-occupied homes. Yet smart speculators know it is difficult to sell an empty or rented house. Popular books about getting rich by "flipping" homes recommend living in the house while you're fixing it up for resale. In the interim, temporarily low adjustable rates act like rent subsidies.
Despite loose chatter about rates being reset to levels "as high as" 11% or more, ARMs are typically linked to interest rates that are now unusually low, such as the 4% rate on one-year Treasuries. Resets rarely exceed three percentage points. Even low-rate teaser loans (not often granted to subprime borrowers) typically set a 7.5% cap on how much the minimum payment can rise in a year.
Christopher Cagan of First American Real Estate Solutions, using a huge sample and conservative assumptions, estimates that "the impact of rate sensitivity and subsequent defaults will be . . . well below one-half percent of total mortgage debt outstanding," and spread over several years. "Reset adjustments to subprime loans may not be as serious as one might think," he finds, because such high-rate borrowers face proportionately smaller increases in monthly payments and (judging by the equity in their homes) were apparently required to make significant down payments.
The greatest risk of people defaulting because of interest-rate resets, Mr. Cagan finds, is from those "making artificially low teaser payments" who now find themselves with no equity because local house prices fell. Teaser loans accounted for 18.4% of all active first mortgages originated in 2004 and 2005, according to Mr. Cagan. Although 2005 was too long ago to qualify, the very idea of freezing rates as low as 1% is bizarre.
The political excuse for getting the government involved in helping a few politically-favored borrowers is based on false assumptions that subprime mortgages were usually used to buy a house, that a huge percentage of subprime loans face foreclosure, and that the main reason for foreclosure is rising interest rates.
All three conventional assumptions were undone by a new study from the Boston Fed. Its research shows that "most subprime loans are refinances of a previous mortgage." It estimates that "about 18% of people who finance home purchases with subprime mortgages will eventually experience foreclosure" within a 12-year period.
Most importantly, the Boston Fed economists found that most foreclosures do not result from adjustable rates going up, but from local house prices going down. They "attribute most of the dramatic rise in foreclosures in 2006 and 2007 in Massachusetts to the decline in house prices that began in the summer of 2005. Subprime lending played a role but that role was in creating a class of homeowners who were particularly sensitive to declining house price appreciation, rather than, as is commonly believed, by placing people in inherently problematic mortgages."
If you owe more money on a house than the house is worth, foreclosure can be a perfectly rational choice. Suppose Mr. Smith bought a house for $300,000 with no money down, but the value of that house has now fallen to $270,000. If he refinances or sells the house, he would still owe the mortgage servicer an extra $30,000. Falling home prices in many areas provide a powerful incentive to default on the loan, live rent-free for many months, and then hand the keys to the bank.
Those who bought homes with no money down have nothing to lose by walking away if they can't resell their homes at a profit. Perhaps that explains why only those with substandard credit ratings are singled out for special treatment under the Bush administration's plan. The "hope now" behind this plan is that people who have good reasons to default will keep paying anyway, even if the value of their houses keeps falling.
Some in the news industry have described all this heavy-handed political intervention as the Bush administration's "free-market approach" to the threat of nonperforming mortgages. On the contrary, honoring contracts and property rights is absolutely essential to the proper functioning of a free society and free economy. A mortgage is a binding contract between consenting adults. A mortgage-backed security is private property. It is the antithesis of a free market for the government to fix prices, pressure mortgage service companies into renegotiating contracts, and thereby expropriate property rights of those stuck holding mortgage-backed securities.
Another president, Richard Nixon, gained ephemeral popularity by freezing wages and prices on Aug. 15, 1971, but the end result was disastrous for the economy. The Bush administration may hope now for some political benefit from freezing interest rates for a select subgroup of high-risk borrowers. But whenever politicians attempt to protect borrowers and lenders from their folly, they just encourage more folly.