Will the Subprime Borrower Salvage Operation Reduce Mortgage Lending?

We are more that a bit skeptical of whether the New Hope Alliance Plan (the name alone instills doubt) to help a subset of subprime borrowers by freezing their initial interest rate is more about creating photo ops than helping meaningful numbers of overextended borrowers. Why are we so dubious? The last smoke and mirrors housing initiative launched by Bush, its FHASecure program, is producing almost no tangible results, an outcome vastly worse that even our critical assessment when the program was spawned.

Housing Wire caught the Reuters story that determined that only 266 borrowers had received aid, versus the level planned of 240,000 a year. Admittedly, the program was inaugurated last August, but even allowing for that, the results to date are, to put it mildly, underwhelming. Paul Jackson of Housing Wire later reported on FHA efforts to muddy the waters and claim significantly more participants by counting all applications, rather than the ones for delinquent subprime borrowers targeted by the new program.

Nevertheless, there is a possibility that the streamlined loan modification process touted by Paulson might help as many borrowers as some analysts envision (estimates from independent sources are as high as 145,000 which of course is considerable lower than Administration forecasts). But even with limited participation, Saskia Scholtes argues in the Financial Times that the program could on balance be detrimental.

From the Financial Times:

Mr Paulson’s plan lays out a framework to classify resetting borrowers based on the characteristics of their loans and their payment history. Borrowers that meet certain criteria will qualify for a five-year freeze of their loan’s interest rate….

But the plan is far from a silver bullet. To begin with, a very small number of borrowers will qualify. According to research from Deutsche Bank, only about 90,000 loans will qualify for the rate freeze – 5 per cent of the loans facing resets in the next two years….

More important is the broader question of moral hazard. Once the government has dipped its toe into homeowner aid, it sets a precedent. Will it look to help other categories of struggling borrower when the market begins to feel the pressure of interest-rate resets for so-called “alt-A” or prime borrowers, a wave of which is due in 2010 and 2011?

Assuming the US housing market has not shaken off the current slump by 2010, this could create another wave of foreclosures which the next administration will be no better equipped to ignore.

And the problem is that loan modification could actually do more harm than good.

Modifications are not without cost. While they may reduce the ultimate losses for investors in the most senior bonds, modifications can also wipe out whatever residual value might be left over for junior investors as the expected future cash flows from higher interest rates are reduced dramatically by the rate freeze.

It is also unclear whether borrowers are likely to keep up with payments after their loans have been modified. Mortgage servicers estimate that up to 40 per cent of borrowers fall back into arrears after the terms of their loans have been changed. And while there has been a tendency to think of the lenders as solely investment banks, the reality is the most lenders are actually individual investors who own mortgage bonds through their pension or mutual funds.

Servicers, who collect mortgage payments on behalf of bondholders, are supposed to modify loans when it is in the best interests of the investors. But defining this on anything but a case-by-case basis is fraught with uncertainty. Sending a blanket offer to potentially troubled borrowers puts loan servicers on much thinner ice.

There is legislation before the House of Representatives designed to protect servicers from such liability, but stripping bondholders of their rights will leave a bad taste in investors’ mouths.

Given the now critical importance of the mortgage bond sector in overall housing finance – half of all US mortgages are financed in this way – any move to dilute bondholder protection is a dangerous strategy that could scare investors away.

That means the benefits of a near-term reduction in foreclosures could be offset by the scarcity of mortgage credit for the long-term.