Software Nerd

Saturday, December 15, 2007

Understanding the Sub-Prime Rate Freeze

Recently, the U.S. government announced a 5-year "freeze" in sub-prime ARM mortgage rates. This is not a law. Ostensibly it is a voluntary decision of various private companies, with the government bringing the parties together. Whether government pressure was involved, I leave mostly to your imagination. [See, ARI's Press release] However, one way to guess, is to understand the terms of the deal, and to judge if it appears like a sound business decision.

Before going on to the details, it's important to point out two things. First, a deal like this would be legitimate if it were truly voluntary. Second, many firms had been calling for an industry-wide standard, voluntary compromise framework. The devil is in the details, though.

Legitimate if Voluntary: Some forum discussions have pointed out that giving poor borrowers a break penalizes the more reasonable borrowers. This is true. However, if the lenders make voluntary accommodations with borrowers, it would be perfectly legitimate. If this announcement was fully voluntary, one would not ask the government to stop it, even if it meant that there would be some consequences that would negatively affect others (e.g. by keeping prices higher than otherwise).

Was it Voluntary? The American Securitization Forum represents many companies in this business. They had previously been calling for industry-wide standards. They wanted standards to deal with the abnormally large number of sub-prime mortgages that will reset in the next two years. Servicers are allowed to act as agents for the investors. They may make accommodations with borrowers. However, they wanted to come to some industry-wide agreement on what types of accommodations would be reasonable. Part of the motivation is that, having such a agreement would reduce the risk that lenders would start suing their agents, either for being too lenient with borrowers, or for being too strict. [For more on mortgage securitization, see my earlier post.]

So, the companies involved in this business have been contemplating a standard. The government's role has been to push them toward a final framework, and -- I suspect -- to ensure that the framework is more lenient on the borrowers than it otherwise might have been.

The Framework: The new framework relates only to sub-prime loans. It is for borrowers who did not have great credit to start out. Either, their credit score was not in the top ("prime") range, or they could not document their income. Also, the framework only relates to adjustable rate mortages (ARMs) with current low "teaser" rates rising to a higher rate in the next two years or so.

Three segments: Broadly, the new framework classifies sub-prime borrowers with ARMs into three segments:

  • Good borrowers: Those who can afford to refinance or to pay the higher rate [e.g. they have enough equity in their homes, or their credit scores have improved since the time they took out their mortgage]

  • Bad Borrowers: Those who cannot afford to pay even the introductory rate [e.g., people who are already delinquent, even though they're on the low teaser rate]

  • Those in the "middle" ("Segment 2"): they've paid so far, but may not be able to pay the higher rate

The announcement does not apply to the "good" and "bad" groups. The "good" group will be expected to refinance of pay the higher rate, as agreed. The "bad" group will face regular servicing procedures: either foreclose, or an individual deal; no standards have been laid down. The group in the middle is large, estimated to be as high as 1.8 million borrowers!

Criteria: The group "in the middle" is identified as follows.
  • They have been able to pay their low teaser rates, thus far
  • They have credit scores of 660 and below,
  • Their credit has not improved much since they took out their mortgage.
  • They owe a large amount, relative to the value of their homes (they have equity of 3% or less), making refinancing difficult, and making it less likely for foreclosure to be profitable to the lender
So far, so good. As such, these are good enough criteria to start to identify borrowers whose ability to pay is in doubt. The next question is: what should be done about this segment?

The solution for "Segment 2": The framework says that these doubtful borrowers will see a freeze in their rates for 5 years. Servicers will not investigate each loan individually. Instead, the servicers will assume that these people, as a group, cannot afford to pay the previously-agreed higher rate. The servicers will freeze their rates at the teaser rate for 5 years. Anyone who is paying "interest only" will start paying principal as well; but, the interest component will remain unchanged.

A drink to the alcoholic: For some borrowers, this "solution" is like giving a drink to an alcoholic, or five more years of liquor!Yes, there will be some borrowers who will be shocked into reality, who will wake up and start to prepare for the day 5 years down the line when their payments go up.

However, it's my guess that many risky borrowers, will simply be in the same position 5 years from now. Some will be shocked out of their ignorance, many will not. The ones who were actually evading the fact that they could not pay, probably won't change.

I think a better solution would have been to start turning the screws. For instance, instead of a freeze, the borrowers could have been asked to pay rates that increased slowly, instead of at a single jump. Rates could increase over the next five years, reaching the agreed-upon rate in the sixth year. Or, freeze the rate, but insist that they pay something toward principal each year, increasing every year. (Those who are on interest-only could have had a slightly modified version.)

Five years of equity-building: The lenders do hope that home prices will stabilize in the next few years, and that 5 years from now, home prices would have risen. Hypothetically, suppose home prices go down 10% in the next year, then stay stagnant for a year, and then rise at 2%, 3% and 5% for the next 3 years. In the fifth year, the average home will end up 5% higher than today. With that, the average borrower will be in a slightly better position to refinance; also, foreclosure will be less of a loss for the lenders. Many of these borrowers had been counting on rising home-prices. So, from that perspective, it makes sense to wait out some period when one can reasonably expect some appreciation.

Inflation: Recently, there have been increasing fear of inflation. If the government ramps up inflation ever so slightly -- say by 1% or 2% a year -- the 5 year scenario will appear even "better". The 5% appreciation will end up closer to 12%. (Of course, this acts as a tax to everyone else in the economy.) Since the Fed is in the beginning of an "easing", slightly higher inflation expectations seem reasonable (even if one does not like it). So, keeping this in mind, it actually does make sense for lenders to wait things out a bit.

In summary: Servicing companies do have the authority to accommodate bad borrowers. In the current situation, it seems reasonable for lenders to clamp down on the truly bad borrowers, to let the good ones pay, but to tide over the next few years with the doubtful ones in the middle. I think a reasonable lender would have tried to separate the wheat from the chaff using a plan that ramped up rates slowly, or something similar. It is my guess that the government put some pressure on them to be more lenient in that regard. However, the framework is probably not way off from what the industry might have reached on its own.

However, just as a few pennies in gas tax is objectionable, having the government push lenders a toward a framework that is not what they would have come to voluntarily is also objectionable. The good guys do end up paying. Also, on the housing front, this framework is probably just one of many things the government will do. I've already mentioned increased inflation. Also, the Federal Housing Administration is touting some new loans for people with poor credit, and obviously there's a tax-payer funded subsidy hidden in there. Also, for tax-year 2007, a new law allows sub-prime folks who pay mortgage insurance (PMI) to deduct it, while they were not able to do so before. If the housing slow down drags on, Congress will likely pass more such laws. It is relief with a thousand band-aids for sub-prime borrowers, death by a thousand cuts for others.

Legal status: There is one more thing to add about the legal status of this new framework. Even though it is not a law, it does carry legal weight. Most servicing contracts allow a servicer to make accommodations with bad borrowers, as long as these are reasonable and customary. Suppose some Japanese holder of US mortgages tries to sue, this new framework basically details new rules that are now "customary". The framework says explicitly: "...upon adoption ... by a substantial number of loan servicers... the fast track ... will demonstrably constitute standard and customary servicing procedures... " (page 10 of the framework). As a non-lawyer I wonder how valid that is: could the Japanese third party expect the standards that were in place when he did the deal and reasonable changes to those, or can he be deemed to have agreed to any new standard as long as it is customary? As for "reasonable", it will be interesting to see what happens if someone sues. The servicers can be assured that the government will declare that they are being reasonable.

P.S.: Oh yes, if you happen to be a sub-prime ARM borrower, with a loan resetting in 2008/2009, do the opposite of what you did when you took out your loan. Where you tried to appear credit-worthy then, try to appear unworthy now. Make sure not to be delinquent. However, do not pay more principal. Do that and a "brother's keeper" will give you a break. [This last bit is tongue-in-cheek.]

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