Subprime Reform Plan Is Just Another Teaser

Bulls like the proposal, but it's rife with long-term questions.
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The Wall Street Journal reported this morning that the Bush administration has gathered together with Citigroup (C) - Get Report, Wells Fargo (WFC) - Get Report, Washington Mutual (WM) - Get Report, Countrywide Financial (CFC) and other mortgage-related companies to formulate a plan to solve the subprime crisis. The group is called the Hope Now Alliance, and the working concept is to temporarily freeze the interest rates for certain troubled subprime loans.

On the surface, this plan seems to favor the irresponsible mortgage companies who made these foolish loans and to be less interested in keeping families in homes.

In a perfect world, the alliance would choose exactly what loans to freeze, and that would reduce foreclosures and stabilize to a very unstable lending environment, and consumers would live happily ever after in homes they had no business buying in the first place -- albeit for only several years.

To review the situation, mortgage companies provided "teaser" rates on adjustable-rate mortgages that lasted for the first two or three years before resetting to an interest rate that could almost double the teaser.

Adjustable-rate mortgages were not a bad idea a few years back, when housing prices were rising by more than 10% annually and borrowers were able to refinance before the two- or three-year period ended as equity in their homes increased.

However, when the real estate market peaked and teaser rates began to reset, borrowers saw their payments jump significantly, straining their budgets. Next year, over 2 million adjustable-rate subprime mortgages worth about $360 billion will reset -- so the need to act fast is imperative.

Looking at the deal, the coalition will only freeze the rate to borrowers who can afford their homes if the teaser rate is extended. One scenario suggests that the teaser rate will be applied for seven years. Treasury Secretary Henry Paulson is at the forefront of the deal, and he said he's been talking to the heads of lending institutions on a daily basis to find the best way to help consumers through this difficult time.

One has to wonder if these are the same people he talked to back in April when he stated, "All the signs I look at

show the housing market is at or near the bottom."

My main concerns are the selection process of the people whom the relief will be provided for and the time factor.

  • Can a simple model determine that during a time when recession could be just a few quarters away, certain borrowers will continue to pay their mortgages even at the frozen interest rate?
  • What will happen in seven years?
  • Will we go through the same reset process?
  • Will these rates continue to be applied in the long term?

What's more, if the economy picks up steam and the housing market bottoms, is it right that these borrowers continue to pay the teaser rate, even though that would be unfair to new homebuyers?

With time becoming a crucial factor, considering the amount of resets that are expected next year, I may be out of line criticizing the first draft of the deal. But it seems this is a win for the mortgage industry and only a temporary remedy for borrowers.

Rather than simply criticize the plan to even the housing playing field, I have come up with my own plan that also opens the door for criticism.

The first step is to extend the time of adjustable-rate loans to 40 years from 30 years. Then, instead of resetting the rate to double the teaser in one fell swoop, raise the interest rate more slowly, perhaps by 1 percentage point annually, with a cap at the then-current 30-year fixed rate. Today's national average is 6.1%, according to

The Wall Street Journal

.

This is a win/win for lenders and borrows. First, banks would extend the time period for loans, essentially earning more money on their investment. Also, this would decrease the rate of foreclosures, since borrowers would have less of a dramatic jump in mortgage payments.

For borrowers, this would allow many of them to keep their homes instead of worrying about being "selected" by the coalition. The interest rate would be higher than the teaser, but if borrowers cannot afford a home at the current interest rate, then, frankly, they should be renting.

As for taking out a 40-year loan (which essentially means that borrowers will be paying mortgages for half of their lives), if the real estate cycle changes for the better or if conditions for certain individuals become more favorable 10 years from now, they could always refinance or even make an extra payment a year to reduce the time on the loan.

This plan has many holes, but if we are to remedy the subprime situation, it's just as important to look at the benefits for the borrowers as well as for the lenders.

In keeping with TSC's editorial policy, Frank Curzio doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Frank X. Curzio is a research associate at TheStreet.com, where he works closely with Jim Cramer and and writes

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. Previously, he was the editor of The FXC Newsletter and senior research analyst for Greentree Financial, and passed his Series 7, 63 and 65. He appreciates your feedback;

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