The Bush administration, along with members of the financial community, claims to have devised a plan that will deal with the subprime problems. By freezing rates on certain subprime adjustable-rate mortgages, the Washington-led team believes it can relieve additional burdens on borrowers and, in so doing, prevent future defaults, reduce the number of foreclosures, stem financial losses and spare the already beleaguered real estate market from additional downward pressures.
It is a huge claim. Even though the plan might help relieve some of today's financial strains, it will do so only at the expense of longer-term costs. Lawsuits will doubtless arise because the plan's provisions summarily alter loan contracts. Worse still, the summary shift in the terms of these mortgage loans will also tend to have a chilling effect on future mortgage lending, as lenders and investors worry about whether the terms of those contracts will protect them in the future.
It is not even apparent that these plans can alleviate much pain. The provisions, after all, offer help only to a rather small subset of mortgage holders. According to the American Securitization Forum, which was a party to the Bush administration's plan, the provisions would cover only subprime, residential, adjustable-rate mortgages that have an original fixed-rate period of 36 months or less. These mortgages must have originated between January 1, 2005, and July 31, 2007, must have an initial-interest-rate reset date between January 1, 2008, and July 31, 2010, and must be included in securitized pools. At most, these provisions would apply to only 1.2 million mortgages, which, as the accompanying table shows, constitute a relatively small part of the outstanding mortgage total. Though the provisions would have applied to the mortgages of many people who recently have been foreclosed upon, they will not stop many other foreclosures on the way.
And not even all these targeted mortgages would get help either. To get assistance, the borrower would have to pass three additional tests: First, the plan would exclude any borrower who in the last year has had more than one payment that is more than 60 days behind. Second, the plan would exclude anyone who could qualify for refinancing. These provisions, the planners estimate, would disqualify some 600,000 mortgages or more. Of those remaining, the plan would disqualify any borrowers whose credit score suggests that they could afford the higher payment after the adjustable mortgage steps up. Those few remaining would get a five-year extension on their introductory interest rate.
Considering the distribution of mortgages in the accompanying table, the plan's own estimates on the number of mortgages involved suggest that, at most, the provisions of this scheme would help some 1.5% of outstanding mortgages, and at its best would help thwart about 8% of the potential number of defaults. Since the nation's overall default rate on all mortgages these days is running at about 1.7% and involves some $200 billion, the plan, it would seem, could, at most, prevent some $16 billion in defaults. For those involved, this is significant. For the nation as a whole or its financial markets, this is neither a make nor a break figure.
Against this maximum potential for relief, the Bush administration's plan also introduces an array of drawbacks, problems that have been enumerated by an equally wide array of critics. Not surprisingly, Democratic presidential candidates Hillary Clinton, Barack Obama and John Edwards separately but uniformly dismiss the plan for failing to go "far enough." Given its limited scope, they may have a point, at least within their own political perspectives. Other Democrats in Congress tend to agree generally with the candidates. Rep. Barney Frank of Massachusetts, for instance, would extend the assistance to others who could afford the step-up in their payments or who might qualify for refinancing. The recently proposed program, he argues, penalizes those borrowers who have acted more judiciously. "Penalize" is probably the wrong word, but the plan does deny them the assistance it would give to other, presumably more reckless borrowers. Arguing this same potential inequity from a completely different perspective, others in Washington and in the financial community criticize the plan for bailing out only those who have acted irresponsibly and at the expense of lenders, many of whom acted in good faith.
Aside from such questions of fairness, other, more telling criticisms focus on the long-term health of financial markets. Just about everybody, for instance, in Washington and in the financial community, concedes that the Treasury Department's plan could provoke huge lawsuits. Such legal problems would presumably arise because Treasury would fail to consult with many of the owners of this mortgage debt, most of whom are in widely dispersed groups of individuals or pension funds that have purchased bonds collateralized by it. Industry practice does give mortgage service companies latitude to renegotiate the terms of a loan, except in the interests in the investors and usually only when changing terms would help avoid a default. Whatever today's general threat, the Bush administration's wholesale approach to fixing the problem will without doubt leave room to argue that the new mortgage terms were not universally in the interests of the investors. Even the American Securitization Forum, while advancing the plan, admits that the arrangement offers no guarantee against suits, despite the Bush administration's endorsement. And the best Treasury Secretary Henry Paulson can offer in his op-ed on the subject is that, "The risk of litigation should be manageable."
In addition to the prospect of future litigation, this plan also raises the risk of a liquidity shortfall in mortgage lending. Quite aside from legal considerations, any seemingly arbitrary shift in the terms of the mortgage contract will introduce huge uncertainties into any future decision to lend mortgage money or buy collateralized bonds backed by mortgages. That uncertainty would add to the usual credit and interest rate risks, an especially ambiguous and unquantifiable element. Unknowns of this sort could easily persuade these prospective lenders and investors to hesitate when considering mortgages and perhaps turn from them to other assets. The resulting slowdown in the flow of future liquidity would hardly help the mortgage market over the long haul.
If this plan required legislation, it would surely get blocked in the Democratic-controlled Congress. But as it is, the industry can go ahead, most notably the mortgage servicers, even as they risk suits and future liquidity problems. There are, of course, practical problems to overcome, which might make the whole effort even less effective than it seems in relieving immediate economic and financial strains. But either way, the plan will introduce longer-term legal and liquidity risks into the market for mortgage finance.
Milton Ezrati is a partner and the senior economic strategist at Lord Abbett. He is also an affiliate of the Center on Economic Growth at SUNY, Buffalo, a 30-year Wall Street veteran, a regular contributor to On Wall Street, and a well-known expert on a range of global and domestic financial issues.