Economy

Paulsen Plan to Ease the Lending Crisis is Full of Holes

Too little, too late.
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.

The real problems?

  • The FOMC, who took rates down to historic lows, and left them there for a year;


  • Ratings agencies, (not unlike the equity scandal of the 1990s) were in cahoots with underwriters, to the detriment of investors;


  • The Federal Reserve, in their capacity of over-seers of the Banking industry, failed to supervise the rampant issuance of irresponsible debt;


First there is the Fed. Alan "throw cheap money at any problem" Greenspan. The bottom line of interest rates is simple. When you lower interest rates to below 0% after adjusting for inflation, you're encouraging reckless borrowing. At those rates, money is literally growing on trees. I love the way classical economists feign complete ignorance of basic supply and demand when it makes them look bad. "Yo -- Alan! You lowered the cost of money to nothing. What in the hell do you think that will do to demand?" For Greenspan to sit back and claim he had no idea a bubble would happen is at best disingenuous.

Second -- the ratings agencies should be dealt with harshly. The key lynch pin in this whole situation is the ability to sell sub-prime backed paper to as many investors as possible. That means you need a good credit rating. While I'm sure all the agencies will swear on the Bible they did the best job they could, consider the number of downgrades we've seen lately. Frankly, to me it looks like a whole lot of CYA going on.

On that note -- as my screen name implies I use to be a bond broker. During my time in the market I dealt with mortgage-backed collateral and structures. The whole securitization process is -- in my opinion -- a great idea and process. But this whole mess is giving it an incredibly bad name -- and one it does not deserve. But it would not be getting a bad name if the ratings agencies had remembered one important point: when you're carving cash flows out of weak collateral, you have to always remember it's weak collateral and no amount of slicing and dicing will change that. If this paper had been properly rated from the beginning, then only higher risk investors would have been buying this paper. And that would have solved a whole lot of problems up front. Instead, everybody was buying this stuff -- and that's a prime reason we're having all of these problems.

And finally, there are the mortgage brokers. Here's the central problem with the advent of consumer friendly modern mortgage products:
Even some smart people overestimate the average borrower's sophistication in these matters—as evidenced by Alan Greenspan's 2004 speech in which he argued that more Americans would benefit from taking out adjustable-rate mortgages. It's a thesis that makes theoretical sense, but seems to assume the average homebuyer understands interest-rate risk as well as someone trading LIBOR (London Interbank Offered Rate) futures at Goldman Sachs.
That's the central issue. I have to wonder how many people who bought option ARMs or interest only loans actually understood what they were buying. And just because they don't get it doesn't mean they're stupid - it just means they don't understand a fairly arcane and obscure financial tool (like about 98% of the people out there). But when a mortgage broker -- who probably gets a higher commission for selling a higher interest rate product -- talks about those great teaser rates and then says, "you can refinance in five years" how many people are going to say no? Or better yet, how many people are going to admit their own ignorance about something and ask questions? The point is the lending industry has a great deal of responsibility here too. And I would bet there are some mortgage brokers who are having trouble sleeping at night for the crap they sold (and I hope they continue to have those problems). The point is the lending industry needs an overhaul in a big way; that will prevent this problem from happening again.

The real problems -- lax interest rate policy, corrupt ratings agencies and questionable lending practices -- are completely unanswered. And that's why the Paulsen Plan -- or the Paulsen Put -- won't solve this problem.

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Hale "Bonddad" Stewart is a former bond broker with several regional firms. He has been involved with the financial markets since 1995. He currently practices law in Houston, Texas. Stewart is the proprietor of the Bonddad Blog.