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The subprime suckers who paid on time

I predict a rising backlash by on-time subprime borrowers against the Bush administration’s Teaser Freezer bailout plan. As far as I can tell, on-time borrowers wouldn’t be helped, even if they are severely stressed. The aid would go only to people who had missed payments. So if you scraped up every last dime to make every mortgage payment, you’re stuck in your lousy loan. Your next-door neighbor who spent the mortgage payment at Disney World gets the bailout. Infuriating, huh?

(New stuff from here down after listening to today’s press conference.)

That’s a bit of an oversimplification, of course. The Bush Administration plan is to streamline the workout process, not change the rules entirely. Presumably, then, not everyone who’s current will be ineligible for help, and not everyone who blew a payment will get aid.

Inevitably, though, any nationwide solution is going to create some winners and losers. And the losers are going to be yelping pretty loudly.

Read this complaint from a guy who got a prudent fixed-rate loan even though it was more expensive than a teaser ARM, knowing that ARMs would reset upward. Now he’s steamed that ARM borrowers are going to get away with below-market teaser rates for the next five years.

Peter Schiff, a perma-bear who rails against America’s overspending ways, thinks that some of the people who were bailed out are going to end up defaulting when the rate freeze ends in five years anyway, and knowing that they won’t take care of their properties. He calls it “the mother of all bad ideas.”

Here’s what he wrote today:

Compounding the problem is that subprime borrowers with frozen payments on loans that exceed the values of their homes will likely chose not to pay property taxes, condo or homeowners fee, or maintain the condition of their properties. Were these properties to be sold in foreclosure at least their new owners would have financial incentives to maintain the value of their investments. Upside-down subprime borrowers will have no incentive to throw money down a rate hole, making additional payments on properties in which they have no equity and which will they will likely lose to foreclosure anyway. When these homes do go into foreclosure, back taxes and other fees on dilapidated properties will inflict even greater losses on lenders.

Also, subprime borrowers with frozen resets will be unable to either borrow additional money against their homes or sell them. As rising credit cards payments, higher food and energy bills, and stagnating wage growth or even unemployment make even paying the frozen rates increasingly more difficult, this lack of flexibility will prove fatal. Also the moral hazard inherent in offering help to only those who can demonstrate an inability to afford the reset rates, or restricting the bailout to borrowers with low credit scores, guarantees that borrowers will alter their circumstances to qualify for the aid. Therefore more loans will be frozen than is currently forecast, and the circumstances of the financial borrowers will be that much more impaired as they endeavor to pile on added debt or reduce their incomes to conform to the requirements of the bailout.

Lost in current discussion is the fact that few subprime borrowers have any skin in the game in the first place. Having put nothing down or having extracted equity in previous refinances, most subprime borrowers will lose nothing if their homes go into foreclosure. In some cases the teaser rates were so low that borrowers actually paid less then what they might otherwise have paid in rent. In fact, those who have already extracted equity have received huge windfalls from their homes and will leave their lenders holding the bag.

At today’s conference, Treasury Secretary Henry Paulson acknowledged in response to a reporter’s question that the fairness issue has already come up: “We’ve heard a number of comments like that,” he said.

His response is that something had to be done about the foreclosure mess and there’s no silver bullet. First, Paulson said that preventing unnecessary foreclosures is good not only for the homeowners, but for their neighborhoods. Second, he said that a lot of the anticipated workouts would have been done anyway, except more slowly. His implication is that the inequity isn’t any greater than it was in the past.

Actually, both arguments are questionable. There are times when foreclosure really is the best option, as Peter Schiff’s comment makes clear. And despite Paulson’s argument that this is purely a private-sector deal, it seems pretty clear that loan servicers are going to feel under heavy political pressure to go easy on homeowners. Once investors realize that they can’t trust their loan servicers to get them as much money possible, they’re going to be more cautious about buying mortgage-backed securities, and the flow of money going toward financing homeownership will slow.

Here’s what Standard & Poor’s said about the plan today. (Note the last part in bold.)

Although loan modifications that extend the mortgage’s fixed-rate period may result in lower defaults, the reduction in excess spread may offset the benefits of lower defaults resulting in diminished investor protection.

Now, putting a little fear into the mortgage-backed market is not an entirely bad thing: there was probably too much investment in housing over the past five or six years.

Funny thing, though. You don’t hear President Bush bragging that this plan will keep zombie homeowners in their dwellings for another half decade while drying up the money necessary to help people buy homes in the future.

A Resolution Trust Corp.-style bailout might have been a cleaner way of dealing with this mess. Makes me wonder whether in its zeal to come up with a solution that could be labeled 100% “private sector” for political consumption, the Bush Administration made some poor choices.

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