How to Fix, Not Break Up, the Subprime Business

How to Fix, Not Break Up, the Subprime Business

By Jack Guttentag
Saturday, June 9, 2007

The federal government is under enormous pressure to do something about the subprime mortgage crisis. The proposals that have emerged appear to reflect concern for abused borrowers in or approaching foreclosure, a desire to punish those responsible for their plight, and the usual urge to score political points.

This is not likely to generate thoughtful reforms that look to long-term consequences. Doing nothing is also an option, and, in my opinion, a better one than most of the other proposals. Here are some principles that reform advocates should observe:

The subprime market is open, so let's not do anything to shut it down. The subprime market has undergone a significant bloodletting, yet it has stayed open for business. Borrowers with poor credit who can't document their income can't get 100 percent loans anymore, but that's a good thing. And borrowers with better credentials that are still not good enough for the mainstream market are still being served.

We should keep in mind that for every subprime borrower in foreclosure, there are at least 10 others who became successful homeowners who might not have made it otherwise. We don't have a substitute for the subprime market. Meanwhile, draconian penalties that could cripple the subprime market should be avoided.

Borrowers who speculated on house-price appreciation and lost should not be bailed out. It would be a travesty if home buyers could enjoy an increase in their wealth when house prices increase but shift losses to someone else when prices decrease. There is no more reason to do that in the house market than in the stock market.

The lien enforcement system should not be weakened. Lawmakers should be mindful that a core requirement of an effective housing-finance system is the pledge of property as collateral for loans, with the ability of lenders to enforce their liens on the collateral. An enforceable lien is what makes possible the $500,000 loan at 6 percent for 30 years to a borrower who, without the house to pledge as collateral, might be able to borrow only $25,000 at 10 percent. While state laws require lenders to observe due process, they are not serious impediments to lien enforcement. Let's keep it that way.

There have been a number of ill-advised proposals. These include a moratorium on foreclosures, which would benefit all borrowers in trouble whether they deserve it or not, seriously weaken the lien enforcement system, and possibly shut down the subprime market, depending on how long a moratorium lasted and how it was implemented. Another bad idea is making loan purchasers and investors legally liable for the misdeeds of loan originators. That would without question shut the subprime market.

I have a more targeted and modest proposal that focuses on the major black cloud on the horizon: the large number of subprime adjustable-rate mortgages with interest rates that will reset to much higher levels over the next two years. Many borrowers with ARMs will be unable to make the higher payments and won't have enough equity in their homes to refinance.

I would mandate a three-year extension of the initial rate period of all ARMs that meet the following conditions:

The first rate reset is scheduled to occur (or did occur) from Jan. 1, 2007, through Jan. 1, 2009.

The loan is secured by the borrower's primary residence. No vacation homes or investment properties.

The loan had an original balance of no more than double the maximum for Federal Housing Authority-backed loans in the property's county. The maximums would thus vary by county, from $400,320 to $725,580.

The loan had a margin of 4 percentage points or more, and a prepayment penalty that extends past the initial rate reset date.

The second and third conditions are crude ways to limit the benefit to the most deserving. The fourth condition is designed to narrow eligibility to the borrowers most likely to need the extension, who are also the borrowers most likely to have been overcharged. (The margin is the number that is added to the interest rate index to determine the new rate at reset. The higher the margin, the higher the new rate.)

The last condition also means that the extensions of the initial rate periods, and the costs associated with the extensions, would be concentrated in the subprime market. Almost all subprime mortgages have margins exceeding 4 percentage points.

Most of the mortgages affected by extension of the initial rate period will be in trouble without the extension. Hence, any additional loss to investors and any effect on new lending should be very small.

Next Saturday, I'll look at whether the subprime market can be replaced.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

Distributed by Inman News Features

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