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Bush Subprime Plan: Too Much or Too Little?

Political meddling on mortgages could make things worse before they get better.
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Treasury Secretary Henry Paulson and Housing and Urban Development Secretary Alphonso Jackson today will announce a plan to help suffering homeowners who used subprime lending. It would mostly affect borrowers who can pay teaser rates but can't afford higher resets.

Sen. Hillary Clinton (D., N.Y.) yesterday addressed the Nasdaq and said of the Paulson plan: "Although the administration is finally giving the foreclosure crisis the attention it deserves, it seems that President Bush is going to give struggling homeowners far less than they need."

John Edwards also issued a plan on Wednesday. The former North Carolina senator's plan is similar to Clinton's but goes further to address the issue of predatory lending. Edwards says: "It's not enough to address the problems of current homeowners -- we must take steps to prevent a future crisis and we must create more affordable housing opportunities for American families."

Sen. Chris Dodd (D., Conn.), after reading a Sunday

New York Times

piece by Ben Stein, warned he might investigate Paulson.

Doug Kass corrected Stein's nonsensical comments yesterday.

None of the Republican candidates for president has commented on the plan.

On the other side of the argument, Andrew Laperriere of Washington's ISI Group commented in

The Wall Street Journal

that any bailout would be misguided: "The primary reason for the spike in subprime delinquencies so far is that many subprime borrowers have taken on more debt than they can pay back using any reasonable interest rate."

What would the plan accomplish? The plan is limited and tries to help homeowners, not speculators. It specifically targets borrowers who have teaser rates that eventually reset to much higher rates. Typically the rates are low for the first two or three years and are known as 2-28s or 3-27s.

For these borrowers, a rate freeze would only prevent foreclosure in the short term. The freeze is voluntary for mortgage lenders, who have no real incentive to participate. Furthermore, the government has no plan to use federal funds to help homeowners make payments -- this doesn't look much like a bailout. Regulations on states would be loosened so that people who are struggling could receive additional aid. The Paulson plan would encourage states to increase aid to homeowners through the issuance of tax-free bonds.

Treasury Secretary Paulson, the former CEO of

Goldman Sachs

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, has been working with a coalition of mortgage lenders including

Citigroup

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,

Countrywide Financial Corp.

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(CFC)

,

Washington Mutual

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, and

Wells Fargo

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called Hope Now alliance. Despite industry involvement, the freeze offers no incentive to investors or lenders aside from avoiding foreclosure proceedings once mortgages reset. A freeze clearly lowers their expected return on investment.

Thus, the plan appears to be no plan at all. It would at best place the onus on mortgage lenders to create greater flexibility in the short term, but it provides no solution at all to the long term problem. Speculative mortgages need to be reworked into safer vehicles.

Clinton has suggested a much more aggressive plan aimed at helping more people stave off foreclosure. It is a three-step plan: 1) observe a 90-day moratorium on foreclosures for subprime borrowers, 2) freeze subprime adjustable rate mortgages for up to five years or until mortgages can be modified to fixed rates, and 3) require status reports on the number of mortgages being modified.

Obviously, this would go further than the administration's plan. But neither plan addresses the crux of the issue. A mortgage happens to be a contract between a borrower and a lender. Do we really want to be in a position where the government changes the playing field and makes legislative changes to modify those contracts? Would it even be legal to do so? The implications of any government deal are far-reaching and need to be better understood.

Given that mortgages are a contract, there's a larger problem here. How do we get the two parties together to agree to these modifications? Mortgages are often repackaged and then sold off to investors. How would the government get all of these investors into a room to make this decision?

Investors have no idea what they hold, nor do they necessarily know how much their securities are worth. Any plan offered -- aside from a wholesale federal bailout plan -- by the government wouldn't make this picture any clearer.

Furthermore, some investors already have taken losses and sold their holdings off to speculators. Some speculators might actually believe they are better off following their legal remedies. They might get greater value by going through the courts, foreclosing and reselling the property.

A plan also would need to round up all of the homeowners. Sure, many of these people would rather renegotiate their loans than the alternative, but is it to their advantage to forestall disaster for a short period only to have to face it again in a few years? Once homeowners figure out how bad a deal they signed, they might decide to walk instead. This seems like a much more likely scenario given that the government plan offers no real incentives for a new and safer loan.

Many homeowners get into trouble for personal reasons. Chad Brand, CEO of Peridot Capitol Management,

writes about a Countrywide Financial keynote presentation at the 37th annual Bank of America Investment conference in September that examined why people get into trouble paying their mortgage.

According to Countrywide, 58.3% of people face trouble because of lost income, another 13.2% have illness/medical problems, and divorce causes problems for 8.4%. Can a government plan really stop these problems? I think not.

Worse, some homeowners will never come forward. They might have made fraudulent claims on their mortgage application and thus have little interest in getting the government involved in "straightening out" their problems.

Even if the two sides got together, it could result in a bureaucratic nightmare. Lenders would have to figure out who does and doesn't qualify for the voluntary program. Then they would have to decide how long to freeze someone's payments and when to reset the payments. This would need to be done on a case by case basis. Companies would have to hire more employees to handle the extra work and would therefore cost them a lot of money to implement.

Chuck Webber, a partner in Faegre & Benson who specializes in financial litigation, explains the problem: "It is unfortunate that when something bad happens in the economic world, many lawmakers react by forgetting or ignoring everything they learned in junior-high economics class. And many governmental responses to the recent woes in the subprime-lending industry show that when our lawmakers forget the basic lessons of economics, they can end up hurting the very people they think they are helping."