More thoughts on the Paulson Plan and the mortgage mess
For one thing, yet another subprime lender is winding down -- H&R Block's Option One. It was previously going to be sold to the buyout firm Cerberus Capital Management. Option One will stop originating new loans right away, resulting in 620 job cuts. But H&R Block is going to keep the firm's servicing operation going in the hope of selling it down the road.
For another, we've seen more warnings about earnings trends at commercial and investment banks. It's clear that the mortgage crisis has precipitated a broad-based pull-back in the credit markets, and that this is reducing earnings power in the financial industry.
But the biggest story, bar none, is what I'll dub the "Paulson Plan." That's the move to ease the burden on subprime adjustable rate mortgage holders who are facing interest rate and payment resets. UBS estimates that roughly 100,000 subprime loans will reset every month for the next two years. The FDIC, for its part, estimates that rates will reset on $330 billion in subprime ARMs between September 2007 and December 2008.
The bailout plan splits borrowers into four groups –
A) Those who can afford their mortgages now, and who can afford them post-reset. These people won’t be helped because they don't "need" it.
B) Those who can’t even pay back their loans at the current teaser rates. These people can’t be helped because their mortgages and homes are just plain unaffordable. Or in simple terms, they probably shouldn't have been homeowners in the first place.
C) Those who can probably refinance if they want to (i.e. they have enough equity and their credit is good enough for them to qualify for a loan given today's lending standards). Paulson would prefer that these people be refinanced into new mortgages, rather than have their existing loans modified.
D) Those who can handle their mortgages at the current teaser rates, but who couldn't afford them if their rates and payments were to reset higher. These people are the ones being targeted for relief, provided they have steady incomes and “relatively clean” payment histories. The idea is that they'll have their interest rates "frozen" for three to five years -- to prevent 7%-9% "teaser" rates from jumping to 11% to 13%.
Paulson also floated the idea of allowing state and local governments to sell tax exempt bonds to raise money to refinance borrowers out of subprime loans. Currently, such bonds can only be used to finance things like first-time home buyer purchase loans.
So what impact will this have? What are the holes in it? Can this really "save" the housing and mortgage markets. I've spent a lot of time digging into those questions since the news broke. So have others. Here are some observations worth sharing:
-- It's going to be tough to get everyone on the same page here. BNP Paribas, for instance, calls the plan a “recipe for serious litigation.” The interests of loan investors, loan servicers, and borrowers aren't always lined up, and ultimately, it's the "owners" of these mortgages that have the final say when it comes to loan modifications. As Caroline Baum at Bloomberg notes:
"Nowadays, subprime loans are bundled, sold, chopped up into pieces and packaged into collateralized debt obligations. The lender -- in this case, the owner of a CDO tranche -- has been replaced by a Cayman Islands hedge fund, a Florida municipality or a German bank. Their interests aren't necessarily aligned with those of the homeowner, not to mention one another.
"The investor who owns the AAA-rated CDO tranche and is first in line to get paid has no motivation to support a modification of the underlying loans; the holder of the residual tranche does."
-- Modified loans frequently re-default. Joshua Rosner at Graham-Fisher & Co. says 40% to 60% of subprime and Alt-A borrowers who have their loans modified end up defaulting anyway within the next two years. Fitch Ratings puts the recidivism rate at a slightly lower 35% to 40% for good modification programs.
So at best, this plan could just lead to a bunch of lenders kicking the can down the road. And at worst, if home values keep falling, it could end up being a bad deal for borrowers. They'll end up making more monthly payments on loans against homes that are declining in value. Then when they go to sell one or two years down the road, they'll find themselves upside down to an even greater degree.
-- Resets aren’t the only cause of foreclosure – or even the major one. As this recent Federal Reserve Bank of Boston paper (PDF link) points out, declining home prices play a “dominant role in generating foreclosures.” A telling statistic: Borrowers are already behind on roughly 25% of subprime loans made in 2006 that don’t reset until 2008.
Throw it all together and here's the bottom line: Yes, the Paulson plan may help some borrowers. But it's not a cure-all. It's going to be very tough to implement. And unless home prices stop falling, it may be mostly for naught.
Look at it this way -- the "Three C's" of mortgage lending are Credit (how the borrower has performed in the past on his debt obligations), Capacity (whether the borrower has the ability to service his debts, based on what the lender knows about his income and payment obligations), and Collateral (the value of the home being lent against).
Right now, debt repayment capacity is poised to weaken thanks to rising unemployment and slowing economic growth. And we know collateral values are falling at some of the fastest rates on record. That means we're going to see more borrowers fall behind on payments due to cash flow problems (i.e. loss of income due to a layoff) -- and see more of those delinquent borrowers end up in foreclosure (because they owe more than their homes are worth and expect prices to continue falling, thereby eliminating the motivation to pull out all the stops in order to "cure" the delinquency).
I'm more interested in the other major foreclosure-relief valve being discussed: Letting bankruptcy judges rework loan terms. Congress is considering legislation that would allow judges to restructure primary home mortgages just like they currently restructure other debts (farm loans, commercial real estate debts, credit cards, etc.). If this legislation were to pass, judges could lower interest rates, extend loan terms, or even offer debt forgiveness. Specifically, judges could "strip down" a borrower's loan principal to the amount of the home’s “fair market value.” The rest could be converted to unsecured debt, which could be wiped away.
There are drawbacks, of course. No solution being discussed is perfect. But if a major contributor to foreclosures is the whole "I owe more than my home is worth -- so I'm just going to walk away" attitude, then something that attacks that head on may be more productive than an interest rate freeze.
Anyway, when more details of the Paulson plan are released, I'll try to add some additional thoughts.