Paulsen Plan to Ease the Lending Crisis is Full of Holes

After reading a ton of news accounts, I am unimpressed. This plan has a ton of holes in it.

First:

The plan seeks to combat a rising tide of foreclosures by making it easier for lenders to freeze the "starter" interest rate for certain borrowers for five years. The initiative includes an agreement, brokered by Bush administration officials, between the loan servicers who would administer a rate freeze and the investors to whom the mortgage debt has been sold. The agreement sets conditions under which rates on certain loans could be temporarily frozen. It isn't binding, but because it has the support of major investors, it is expected to give loan servicers much more flexibility to quickly rework some loans and direct other borrowers toward refinancings.

Not binding. That means if a servicer wants out, there is nothing keeping them from going. However, if they leave there will probably be a lot of bad press. That may keep them in whether they want to or not. But a binding commitment would be far more solid.

Secondly

Among those sure to be disappointed are borrowers whose introductory rates expire before Jan. 1. About $57 billion in subprime loans were scheduled to be reset at higher rates in the final three months of this year, according to estimates by First American LoanPerformance.

Mortgage companies could also exclude borrowers who they conclude are making enough money to afford higher monthly payments. Barclays Capital — extrapolating from a similar program recently unveiled in California — estimates that only about 12 percent of all subprime borrowers, or 240,000 homeowners, would get relief.

Remember, what we're trying to avoid here is a flood of foreclosed properties on the market that would swell the super-glut of available home inventory to painful levels that would literally crash prices. Projections are for 1.2 million foreclosures next year. If this plan only helps 240,000 not enough people will be helped to prevent that from happening.

The Wall Street Journal Offered a more optimistic view of the number that would receive help:

The 1.2 million borrowers relatively current in their mortgages will be considered for the government-endorsed program. They will pass through the next set of screening to determine whether they can refinance at more-favorable mortgage rates. Some 600,000 borrowers are expected to qualify. These borrowers are expected to be offered counseling and a fast track to secure refinanced mortgages.

The remaining 600,000 won't qualify to refinance their existing mortgage, the alliance estimates. Such borrowers' loan servicers or counselors would determine whether they can afford to pay the higher interest rates once their introductory rates expire. The servicers will assume that those with better credit scores and more equity can afford to pay when their existing loans adjust upward. They would receive no special assistance.

It looks to me like the plan is saying "refinance people with a credit score below 660, and tell those above to tough it out." If that is true, than we still have 600,000 who may have problems when rates reset. My guess is that will still have a negative impact on the existing homes inventory. Remember -- there is already a 10.8 month supply of existing homes for sale at the national level. The absolute number is near a record. What we're trying to stop is a a further swelling of an already bloated inventory level. With 600,000 still having to deal with an adjustable rate mortgage, I'm just not sure we've dealt with that.

Third:

The assumption is that resetting rates causes delinquency and default. I am not sure this is correct. Research suggests that falling house prices and loans to folks without the income to pay are the leading issues. Delinquency research published in the September 2007 IMF Global Financial Stability Report (pdf) suggests trouble starts before interest rates reset upward. The chart (Figure 1.6) below makes this clear. The below data suggest that as we move forward in time, more folks are defaulting faster and faster. These defaults are not predominantly the result of resets. We know this because a rising portion of people are missing payments before rates change.

This is an incredibly astute point. The problems we're currently experiencing have occurred before resets occurred. In other words, this plan won't solve the current problem.