The federal government is presently under enormous pressure to “do something” about the subprime crisis. The various proposals that have emerged appear to reflect concern for abused borrowers in or heading toward foreclosure, a desire to punish those responsible for their plight, and the usual urge to score political points.
This is not a brew likely to generate thoughtful reforms that look to long-term consequences. Doing nothing is also an option, and in my opinion, a better one than most of the proposals that have emerged. Here are some principles that reform advocates ought to observe.
The Subprime Market is Open, So Let’s Not Do Anything to Shut it Down: As I noted last week, the subprime market has undergone a significant blood-letting, yet for all that it has stayed open for business. Borrowers with poor credit who can’t document their income can’t get 100 percent loans anymore, but that’s a good thing. And other borrowers with better credentials, though not good enough for the mainstream market, are still being served.
We should always keep in mind that for every foreclosure of a subprime borrower, there are at least 10 others who have become successful homeowners who might not have made it otherwise. We don’t yet have a substitute for the subprime market — that possibility is the topic of next week’s article. Meanwhile, draconian penalties that could cripple the subprime market should be avoided.
Borrowers Who Speculated on House-Price Appreciation and Lost Should Not Be Bailed Out: It would be a travesty if house buyers can enjoy an increase in their wealth when house prices increase, while shifting losses to someone else when prices decrease. There is no more reason to do that in the house market than in the stock market.
The Lien Enforcement System Should Not Be Weakened: Lawmakers should be ever-mindful that a core requirement of an effective housing finance system is the pledge of property as collateral for loans, and the ability of lenders to enforce their liens on the collateral. An enforceable lien is what makes possible the $500,000 loan at 6 percent for 30 years to a borrower who, without the house to pledge as collateral, might be able to borrow $25,000 at 10 percent. While the laws of the various states require lenders to observe due process, these are not serious impediments to lien enforcement. Let’s keep it that way.
Ill-Advised Proposals: These include a moratorium on foreclosures, which would benefit all borrowers in trouble, whether they deserved it or not, seriously weaken the lien enforcement system, and possibly shut down the subprime market, depending on how long the moratorium lasted and how it was implemented. Another bad idea is making loan purchasers and investors legally liable for the misdeeds of loan originators. This would shut the subprime market without any question.
A More Targeted and Modest Proposal: My proposal focuses on the major black cloud on the horizon: the large number of subprime ARMs with interest rates that will reset to much higher levels over the next two years. Many of the borrowers will be unable to make the higher payments and won’t have enough equity in their homes to refinance.
I would mandate a three-year extension of the initial rate period of all ARMs that met the following conditions:
1. The first rate reset is scheduled to occur (or did occur) during the period Jan. 1, 2007, through Jan. 1, 2009.
2. The loan is secured by the borrower’s primary residence — no vacation homes or investment properties.
3. The loan had an original balance no more than twice as large as the current FHA maximum in the county in which the property is located. The maximums would thus vary by county from $400,320 to $725,580.
4. The loan had a margin of 4 percent or higher, and a prepayment penalty that extends past the initial rate reset date.
Conditions 2 and 3 are crude ways to limit the benefit to the most deserving.
Condition 4 is designed to narrow eligibility to the borrowers most likely to need the extension, who are also the borrowers most likely to have been overcharged. Note: The margin is the number that is added to the interest-rate index to determine the new rate at reset. The higher the margin, the higher the new rate.
Condition 4 also means that the extensions of the initial rate periods, and the costs associated with the extensions, will be concentrated in the subprime market. Almost all subprime mortgages have margins exceeding 4 percent.
Most of the mortgages affected by extension of the initial rate period will be in trouble without the extension. Hence, any additional loss to investors and any effect on new lending should be very small.
Next week: Can the subprime market be replaced?
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.