Why freezing adjustable rate mortgages at their teaser rate won't help

FDIC chairwoman Shelia Bair raised the ire of the anti-bailout crowd when she proposed that lenders be required (or encouraged) to “freeze” subprime adjustable rate mortgages at their initial “teaser” rates to ensure that homeowners who can currently afford the mortgage payment are not forced in to foreclosure by the exploding interest rate change that occurs at the end of the short-term fixed-rate period. The idea is simple enough, if the initial interest rate on the loan was 4.75% for 2 years and then adjusts to a much higher rate, simply eliminate the adjustment and people continue to stay current on the loan. This, in turn, reduces foreclosures due to unaffordable mortgage payments caused by absurdly high interest rates.

Of course, consumer groups are coming out of the wood work to support this type of initiative.

“We support Chairwoman Bair’s recommendation,” says Alan Fisher, executive director of the California Reinvestment Coalition. “In our meetings with major lenders, this is what we have asked them to do. We will continue to call for a moratorium on foreclosures of subprime loans until recommendations like Chairwoman Bair’s are in place. Without adoption of such loan modifications California will experience an economic Tsunami.”

The California Reinvestment Coalition along with the Woodstock Institute, Neighborhood Economic Development Advocacy Project of New York and Community Reinvestment Association of North Carolina welcomed Chairwoman Bair’s proposal after warning regulators and Congress for years that irresponsible underwriting standards among America’s largest lenders would eventually fuel a crisis in the housing market.

I have some major problems with this proposal. First, this simply exacerbates the current problem with housing, which is mainly, the unsustainable price of homes in America. If home prices return to a level of affordability this situation rights itself, people start buying homes, start fixing them, and start moving up again. But it must start with a return to affordability of the underlying asset. Keeping people in homes on artificial credit terms only props up a bubble that is clearly a major economic anomaly and risk to the economy. Let’s take the pain now and get on with it.

Second, it punishes the fiscally responsible. How would you like to know that you chose a loan with an interest rate 1.5% – 2% higher than the teaser rates on some of these adjustable rate mortgages because you saw the dangers with them; only to realize that by doing the responsible thing you’ve been penalized as your neighbors with the ARM loan are getting a sweetheart modification to keep them at the low 4.75% they started with? I think this defines moral hazard.

Most importantly however is the problem clearly articulated in an (unwitting?) comment from Sarah Ludwig, spokeswoman for one of the groups supporting this bill:

“The solution Chairwoman Bair proposes will help a large subgroup of homeowners who were sold hybrid loans and can afford to pay the introductory rate for the life of the loan,” said Sarah Ludwig, Executive Director of the Neighborhood Economic Development Advocacy Project (NEDAP), in New York City. “Too often, however, even the introductory rate is unaffordable, and servicers will need to ensure that loans are modified on terms that are affordable to borrowers.”

Ms. Ludwig keenly points out that even with a modification these subprime adjustable rate loans will still be unaffordable at the teaser rates they were initial offered at. AND WHY IS THAT? Because people over-stated their income 50-150% on their applications to qualify for these short-term ARMs. That’s why! People can’t afford the payments at the teaser rate, because they could never afford the property. What should lenders do? Give them the home for free? If they over-stated their income on the loan application to qualify for a 2-year teaser rate ARM and now can’t even afford that payment they can’t be saved and shouldn’t be saved!

If you lied on your loan application why is the lender supposed to bail you out with a loan modification? Are they supposed to help you out because you defrauded them? And, based on my unscientific survey of people looking for loss mitigation this is exactly the problem they are faced with. Even taking in to account a favorable loan modification they would still be in a negative monthly cash flow position. Lenders won’t modify a loan where people continue to be in the red each month because they know they are only delaying the inevitable.

People were able to live in this negative cash flow situation over the last 5 years by repeatedly tapping home equity to support their monthly cash bleed. Now, even a modification won’t help because they aren’t able to strip equity out of their home to fund an unsustainable lifestyle.

In summary, modifying loans on a case-by-case basis seems to make the most sense. A moratorium on adjustable rate mortgages seems ill-conceived and bound to help fewer people than it will end up hurting. What do you think?