Subprime lenders are doing what comes naturally

ANALYST'S VIEW

What do Treasury Secretary Hank Paulson, the mortgage industry and investors in securitized loans have in common? They have "Hope Now'' that the so-called alliance to help subprime borrowers hang onto their homes will prevent the real-estate market, not to mention the rest of the financial system, from imploding.

Last week, a gaggle of officials from an acronym-heavy group of housing and regulatory agencies took to the podium to praise the "Hope'' plan. A White House fact sheet touted the initiative as "an example of government bringing together members of the private sector to voluntarily address a national challenge "� without taxpayer subsidies or government mandates.''

Calling the plan voluntary is a stretch. No one put a gun to lenders' and investors' heads. But when the US government asks the banks it regulates to come up with a rescue, financial institutions aren't about to say no. Lenders already had every incentive to work with delinquent borrowers to avoid costly foreclosures.

"It seems to iterate the solution that would have occurred without a plan forged by the government,'' said Paul Kasriel, director of economic research at the Northern Trust in Chicago. "If you're a lender and the borrower can't pay, you decide how to minimize your losses: foreclose and sell the house, or work out an arrangement.''

Plan b
Option B makes even more sense when loan delinquencies are rising and home prices are falling. "That's what would happen in a free-market solution,'' he said. "The first reaction on the part of the lender is not to foreclose.''

The homeowners' relief plan presented last week provides several options to subprime borrowers who can afford the current teaser rate, but not the higher reset as specified in the original loan.

Eligible parties (borrowers with a subprime adjustable-rate mortgage originated between January 2005 and July 2007 with an initial reset between January 2008 and July 2010) will get help in refinancing into a new private mortgage or a government-guaranteed loan. The third option is a freeze on the introductory teaser rate for five years.

A couple of things jump out at you. For starters, it's not intuitive why those who qualify for a "new private mortgage'' need consideration under the streamlined evaluation process. Their inclusion promotes the impression the government is interfering even as the government struggles to emphasize the "private sector'' nature of the initiative.

'Despair later'
While the Federal Housing Administration, the government agency that insures mortgages, is funded by premiums, the more deadbeats shoehorned into FHA-insured loans, the greater the risk of a taxpayer bailout.

"Hope Now'' may end up as "Despair Later,'' Kasriel said, as subprime containment proves to be a myth. Last week, the Mortgage Bankers Association reported an increase in delinquencies and foreclosures in all categories of mortgages, from subprime to FHA-insured to prime.

Finally, while the Bush administration is clearly trying to limit potential liability by getting all hands on board, an unprecedented modification of servicing agreements opens the door to lawsuits. Contractual Obligation
"Servicers are not only authorized, but obligated to consider and pursue loan modifications and other loss mitigation steps'' when recovering contractually promised interest and principle payments look unlikely, said George Miller, executive director of the American Securitization Forum, a not-for-profit industry association representing investors, issuers, servicers and other market participants.

In a small minority of cases, the servicer is "prohibited from modifying'' the contract, in which case, "the contract rules,'' he added.

Miller said the plan, which was "encouraged,'' not concocted, by the government, is a "recommended framework'' that does not exclude other types of loans. (So, no "Son of Hope'' plan required?)

The stock market has given its thumbs up to the plan even as the financial press cries foul. (On the left, it's too little too late; on the right, it creates moral hazard.)

Just look on the bright side, Kasriel says. It's "not as bad as it could have been'' and prevents "the yo-yos in Congress'' from doing far worse.

Keynes writ large
Still, the appearance of rewarding homeowners who bit off more than they could chew is not the sort of precedent the government wants to set. So why bother doing anything?

"It's a PR coup for the administration,'' according to Kasriel. "They forged a plan that would have occurred anyway.'' It's a familiar response. When losses reach a critical mass and threaten to undermine the financial system, the cry goes out for the government to "do something.'' Regardless of the political persuasion of an administration and Congress, they do.

Perhaps the late British economist John Maynard Keynes said it best: "If you owe the bank a hundred pounds, you have a problem. But if you owe the bank a million pounds, the bank has a problem.''