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Time for the Government to Go Far Beyond Rate-Freeze Plan for Borrowers

By Jack Guttentag
Saturday, January 12, 2008

Last week, I predicted that the tight mortgage market will ease when investors regain their confidence, which won't happen until they see a floor in house prices and a peak in foreclosures. Neither is yet in sight.

Housing markets are always slow to adjust, partly because sellers are in denial and are stubborn about reducing prices, while many buyers defer purchases because they expect prices to decline. Rising foreclosure rates strengthen this attitude among buyers because buyers understand that foreclosure sales depress prices.

The peak in foreclosures is not yet evident because of the large overhang of interest rate resets on adjustable-rate mortgages. Because many borrowers facing rate resets will find their new payments unaffordable and will not have the equity or credit to refinance, the outlook is for continued increases in foreclosures. The hope, however, is that the relief plan orchestrated by Treasury Secretary Henry M. Paulson Jr. will change this expectation.

The federal government initiated and to some degree orchestrated the plan, the details of which were released last month. No government funding is involved in it, however. It is a private initiative developed by the American Securitization Forum, an organization of firms involved in the mortgage securitization process. The plan applies to just one category of firms belonging to the organization: servicers of securitized ARMs.

The primary goal is to reduce foreclosures of securitized ARMs facing rate resets by extending the initial rates for five years. The eligibility rules are designed to make implementation possible on a wholesale fast-track basis, as opposed to the slow case-by-case basis that is the rule otherwise. It is also intended to be consistent with the contractual obligation of servicers to modify loan contracts only when it is in the interest of the investor.

Borrowers eligible for the fast track:

  • Took out ARMs with initial rate periods of two or three years between Jan. 1, 2005, and July 31, 2007.

  • Face rate resets from Jan. 1, 2008, to July 31, 2010, that will increase their payments by more than 10 percent.

  • Occupy the property as their principal residence and have been current on their payments for 12 months before the rate reset.

  • Will be unable to meet the payment increase, as indicated by a FICO credit score lower than 660 and not more than 10 percent higher than it was at origination.

  • Will be unable to refinance, either because the original loan was more than 97 percent of property value or because they don't qualify for Federal Housing Administration financing.

    Not eligible are borrowers who have already had their rates reset, borrowers with high-rate fixed-rate mortgages, borrowers who made down payments larger than 3 percent, borrowers with good FICO scores, and those who have substantially improved their scores. Many of these borrowers, while ineligible, are also struggling.

    The inequities are obvious but should be kept in perspective. Those not eligible are no worse off than they are now, and perhaps a little better off. Treating a significant category of borrowers on a wholesale basis will free up more time and resources for dealing with other borrowers case by case.

    The major shortcoming is not the unequal treatment of groups of equal merit, but the fact that the eligible group is too small to have a decisive effect on market expectations. I view this relief plan as a good first step -- about the most that can be expected from the private sector. It remains for the government to take the next step, which should be aimed at tripling, at least, the number of borrowers offered relief.

    Government should mandate that, with the exception noted below, all ARMs originated after Jan. 1, 2005, with rate margins over 4 percent should have their margins reduced to zero. The margin is the spread added to the interest rate index in calculating the new rate after the initial rate period ends. The rule should apply whether the loan has reached its first rate reset or not.

    The exception would be any mortgage for which the lender can document that the borrower was informed of the margin at least three days before closing.

    Having government set aside existing private contracts is not a matter to be taken lightly, but in this case, it is well-justified. The margin on an ARM is a critically important number to the borrower, but because it doesn't kick in until the first rate adjustment, most borrowers don't ask about it.

    Margins higher than 4 percent are found only on subprime loans, and these borrowers are the least likely to ask about details. The fact that government is too inept to make the margin a required disclosure should not absolve lenders of the responsibility for disclosing it.

    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.

    Copyright 2008, Jack Guttentag

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