Wednesday, December 5, 2007

Why Freezing Rates is Bad and Danerous Policy

According to Fox News, the President has reached an agreement to freeze rates on Adjustable Rate Mortgages for five years.

Congressional aides say the Bush administration has hammered out an
agreement with industry to freeze interest rates for certain subprime mortgages
for five years in an effort to combat a soaring tide of foreclosures.

These aides, who spoke on condition of anonymity because the details have not yet been released, said the five-year moratorium represented a compromise between desires by banking regulators for a longer time frame of as much as seven years and industry arguments that the freeze should only last one to two years.

Another person familiar with the matter said the rate-freeze plan would apply to borrowers with loans made at the start of 2005 through July 30 of this year with rates that are scheduled to rise between Jan. 1, 2008, and July 31, 2010.

This is a dangerous and bad policy on several levels.

1)Whenever the government steps in on a private contract and renegotiates it, it leads to all sorts of unintended consequences. In this case, banks use extremely sophisticated modeling techniques to determine the interest rate that borrowers receive. Those models take into account whether or not a rate will eventually begin to move or not. By freezing rates for five years, he has thrown those models totally out of whack. In other words, the risk profile of these loans no longer matches the rate as determined by the models. This not only throws banks out of whack but Wall Street as well that turned those mortgages into bonds.

Whatever liquidity problems are currently in the market, those are nothing like the liquidity problems that will be created when loan terms are changed wholesale. If banks don't receive the rate, and the underlying payment, that they expected, then we will really see some liquidity issues. Remember, one, banks expect to take homes when payments aren't made, and two, they expected certain interest rates and payments from mortgages. Now, they will get neither, and their money is tied up expecting both.

This nightmare is further perpetuated because the definition of sub prime is not clearly defined. For instance, one of the big problem mortgages are option arms. Many of these mortgages are what we refer to as monthly ARM's. That means their rate changes every single month. If Bush includes these into sub prime, he will simply create a nightmare for the banks. Since they are monthly ARM's you can bet that much of the underlying rate was based on a model that had that rate moving every month. If that rate is now frozen for five years, you can bet that banks will take a giant financial hit.

Keep in mind that if you don't care if banks take a hit, you should. If they take a hit, they will pass that hit onto the consumer in terms of higher rates on all future mortgages.

2) Bush has now also created a moral hazard. The folks that he is saving took on a mortgage profile, a rate that adjusts, that they shouldn't have. This was entirely by choice. Now, he is stepping in and stopping an event that is supposed to happen to an Adjustable Rate Mortgage. Instead of learning a difficult and valuable lesson, these folks will now get the message that risky financial moves can be met with government interference to save them before those risky moves turn into consequence.

3)Bush has now created a litigation nightmare. There are all sorts of folks that are currently in fixed rates, five year Arms, and other loans in which their rate either doesn't adjust or hasn't yet adjusted. Those folks are holding onto mortgages with higher rates than the folks who's rates he has artificially frozen. They will all scream bloody murder and demand that their rates be adjusted downward. They will be right. Imagine if you took on a fixed rate which was a higher rate than the equivalent adjustable rate. You did this with a certain financial loss, at least initially, because that rate was higher and with it the payment. Now, you hear that folks that didn't take the same precautions as you are now having their rates frozen for them artificially and will now enjoy lower rates, artificially again, for at least five more years. You would, rightfully so, feel entitled to the exact same rate. You would likely get a lawyer and I firmly believe that Bush has now opened banks up to all sorts of lawsuits.

4)Finally, and this is coming from an insider. This rate freeze isn't going to do anything of substance. The people that Bush thinks he is helping are in over their heads. I know because 99 times out of a 100 my borrowers always bought a property that was more expensive than one they claimed they wanted to buy. The sort of sub prime borrowers that Bush thinks he is helping are irresponsible. They bought 250,000 dollar homes when they could only afford 200,000 homes.

That dynamic is not going to be changed by freezing rates. These folks maybe able to afford to make these payments for a while longer but not forever. They are still in over their heads. Also, what about all of those folks that are in Prime loans that are adjustable rates. Won't they also demand that their rates be frozen? Won't everyone who is on time demand that their rate either be frozen or lowered? By helping the most desperate and the most irresponsible, Bush has now opened up a can of worms that he frankly can neither predict or control.


Now, a mortgage colleague of mine tells me that a radio report says that the only loans that will be affected will be those that are according to him, "on time". On time is rather nebulous. For instance, on time could mean current. It could also mean always on time. If he is only helping those that are always on time, then he is frankly taking all sorts of profit potential away from banks, because those folks most likely would have continued to be on time with or without the freeze. If he is talking about those that are on time now, but have been late, then he is delaying the inevitable. Either way, if it isn't defined clearly, I can assure all that it will be another litigation nightmare.


Sam said...

Right on. The message this sends is: Pay your mortage on time, your rates go up; be irresponsible, take a mortgage you can't afford and your rates are frozen. If i had a subprime loan and paid on time, i would be livid at the fact that my government is coming ion and letting people off the hook who did not pay their mortgage on time. I would also file a lawsuit because this deal is a blanatnt violation of the 14th amendement and 10th amendment.

Anonymous said...

As a threshold matter, I treat any comment that begins by citing a politician with a healthy dose of skepticism. I'm not knocking politicians for doing their jobs. I'm just stating the obvious--their views are extremely skewed.

As for freezing Rates, while I respect the poster's opinion, it is built on a false premise. One artificially jaded by his admitted "insider" position. In plain English, the arguments seems to be as follows: Capitalism depends on freedom to contract. When this freedom is interrupted, the system breaks down and everyone suffers the consequences for a few bad decisions. In the poster's view, the present mortgage crisis was largely created by a few economically and intellectually inferior individuals taking on financial burdens they should have known they could not carry. Now, according to this view, the government is interfering with an important moral and intellectual lesson that the gullible, but benevolent lenders are poised to teach. Moreover, because of this, the banks will be forced to retaliate by raising everyone's rates.

As previously stated, this position is replete with foundational flaws.

First, lenders may be gullible, but they are far from innocent. Brokers, Banks, and title companies have, for several years (at least), colluded to mislead so-called sub-prime consumers who approach them from a bargaining disadvantage due to their, again, so-called spotty credit profiles. Tellingly, the prime/sub-prime distinction is a banking industy invention intended to allow banks to charge usurious interest rates. And, hidden finance charges, fees and penalties have increased the number of technical defaults (via hidden universal default provisions) and (along with other predatory practices) have resulted in an increasingly small prime consumer population. But, as of late, the mortgage industy has taken deception to a new low.

Which brings me to my next point. Other than credit histories (many of which--despite the Fair Credit Reporting Act and consumers' diligent efforts to update the information--contain vague and/or incomplete negative references many years old), the vast majority of sub-prime homeowners are just as financially able as prime consumers. They are doctors, lawyers, accountants, CEOs, etc. The average sub-prime homeowner pays his mortgage, his HOA, and his taxes on time, despite paying, in many cases, twice as much as his counter-part for the same home.

Contrary to the most prevalent explanation, it is not their ability to pay for the house they purchased that is at issue. Instead, it is their ability to pay the concealed premium on that house that neither they nor their counter-part can afford.

Take for instance, the Jumbo two-year interest only ARM. If you believe the poster, these people were fully informed about the affect of the LIBOR index (or, at least, knew what it was) on their loans after the 2-year interest only period. They knew that the interest capped out at, say, 12.7% from a teaser of 7.0% and that the rate would reset multiple times (every six months). They were also informed that very few if any finance companies would refinance such a loan. I think not.

This characterization strains credability and common sense. No one would knowingly agree to such terms. The Brokers and the lenders with their secret kick-back deals assured these consumers that, though the loan would reset (giving no mention of multiple resets or the actual dollar value of the payment increase), the consumer would refinance before then. They also routinely fail to explain the variabl interest rate provision of the contract, in part, because they can't understand the LIBOR themselves. If they do understand, they know that the deal would be dead on the table if they told the customer that his payments would go from $3700.00 per month to $5000.00. So, instead, they point to the page and vaguely reference a reset at the end of the 2-year period, skipping any details. If, by chance, they are selling to an attorney, they simply let the person read it. But, unless you work within a lending institution and regularly deal with such provisions, even an attorney will be completely lost (One does not usually have the final documents until he is sitting at the table at the title company). So, most will rely on the broker's interpretation, thinking, "at worst, I will have to refinance at the end of the term." So, the customer is a little gullible too.

Finally, as to the legal implications--and I'm an insider on this issue--this country has not seen the magnitude of litigation against major banking institutions that is currently in in the pipeline since Worldcom.

mike volpe said...

First this poster wrote another piece describing all the players involved in the crisis...

I never blamed a few "intellectually inferior" people. I blamed a complicated network of events. I said that the people the President is saving are in over their heads. Freezing their rates is not going to change that dynamic. They are not the only ones to take responsibility for the crisis and everyone this anonymous person blames, and more, are responsible and furthermore they are mentioned in my previous piece. Since I already wrote a piece about who is responsible, I didn't think I needed to rehash the issue. My point was that freezing rates wasn't going to help those that Bush thinks he will help. It is quite ludicrous to have someone with no knowledge of the crisis claim that my thoughts are flawed when they are so naive of what happened, and most importantly, my thoughts on the matter, which could easily have been found by surfing my blog.

As it is, your condescending, and ultimately total ridiculous thoughts, are here for everyone for all time.

I am not jaded just knowledgeable from six years in the industry.

The reason that everyone involved agreed to the terms they did is because everyone involved believed that property value would go up forever. I refer to this as irrational exuberance, but frankly I am just repeating myself from a previous diary.

While there are wealthy people that are found in the sub prime category, to claim that they are nearly as plentiful in sub prime as in prime is patently ridiculous. Of course, the numbers in sub prime are skewed to the poor. I know this not only from scientific data but from six years in the industry. While there are doctors and lawyers with poor credit, it isn't nearly as many as professions that make significantly less. While income is not a guarantee of good credit, it certainly is much easier to make your payments when you make more money.

Besides, I really never called anyone poor, just irresponsible. There were a lot of irresponsible people getting loans because banks opened up their programs to such people. I know this because I was in the industry when this happened, again, unlike this condescending and naive anonymous poster.
Since I won't repeat myself, I will simply direct everyone to my previous piece again which refutes most of what this anonymous poster who clearly thinks they know a lot more than they actually know. Thus, here is my piece again...