The crash in subprime lending has put Federal Reserve Chairman Ben S. Bernanke in an awkward position. In past business cycles, when the Fed raised interest rates, the impact was democratic: Companies large and small had to pay more to borrow, and so did most households. Everyone suffered.
This time around, though, most borrowers have been able to escape the Fed's interest-rate hammer. As the Fed has boosted short-term rates by more than four percentage points since 2004--the biggest move since the early 1980s--corporations and households with good credit have easily switched to long-term loans, where rates have barely budged over the past three years. "A prime borrower has options," says Robert Moulton, president of Americana Mortgage Group Inc., a Manhasset (N.Y.) mortgage broker.
Which leaves one group of Americans to absorb the brunt of tight money: families with poor credit. These typically low- to moderate-income families have always relied heavily on short-term borrowing. But they are even more vulnerable today because so many of them bought homes during the boom using subprime adjustable-rate mortgage loans (ARMs) tied to short-term interest rates. As rates have gone up, loan payments are beginning to skyrocket.
The numbers involved are enormous. About $265 billion worth of subprime loans are scheduled to have their rates adjusted upward in 2007, estimates analyst Michael Youngblood of Friedman, Billings, Ramsey & Co. (FBR ) in Arlington, Va. And because money for subprime loans has dried up in recent weeks, it's going to be far harder for these borrowers to refinance. The result: Many stretched homeowners may soon be paying 11% or 12% on their mortgages, while everyone else can get 30-year fixed-rate loans at a little over 6%. That's the plight of Pamela G., a blind mother of three in Golden Valley, Minn., who is a medical transcriptionist. Her monthly payment just jumped to $2,544 from $2,088 and is headed higher. "Unfortunately," she says, "the gal did not overly explain to me that once the three years [of the teaser rate] were done, the rate would boot way up."
In effect, monetary policy is turning into a regressive tax, putting the Fed and Bernanke in a bind: If he holds rates at current levels without regard to the impact on subprime borrowers, foreclosure rates over the coming year could approach recession levels. On the other hand, if the Fed starts lowering rates to spare subprime borrowers from default, it risks letting inflation accelerate, which would harm everyone.
Most economists argue that the economy is healthy enough to withstand the problems in subprime. That's partly because the Fed's 17 rate increases have had a relatively narrow impact. Today only 28% of nonfinancial corporate debt is tied to short-term rates, much lower than in the past. Interest payments on corporate debt have risen only by $30 billion since 2004--a pittance when profits have leapt by more than $300 billion.
Similarly, families with better credit have been able to escape the short-term squeeze by switching to fixed-rate mortgages. Take the case of a hypothetical prime borrower who took out an ARM loan two years ago and saw the rate reset after one year. The starting rate was about 4%; it would have gone up to about 7.5%. But instead of absorbing the near-doubling of the rate, this prime borrower could refinance into a 30-year fixed-rate loan at a bit over 6%. In other words, an increase of five percentage points in the Fed funds rate translated into only a two percentage-point increase in long-term rates for the homeowner.
Nor have car buyers been hit hard by the rate increases, even though the auto sector was a key channel for monetary policy in the past. According to data from the Fed, the interest rate on banks' car loans has increased by only 1.5 percentage points since 2004.
Homeowners with subprime loans aren't as lucky. Few seem to have understood their exposure to Fed rate policy when they took out their mortgages. The most popular are hybrids whose rates stay fixed for two years, then adjust periodically over the next 28 years based on a set percentage over a short-term benchmark such as the London Interbank Offered Rate (LIBOR). Opponents call them "exploding" loans because the rates stay artificially low during the two-year teaser period, then leap. In the industry, they're known as 2/28s.
ESCAPE ROUTE CLOSED
The 2/28s now coming up for their first reset were made in early 2005. It seems crazy now, but when the loans were made, nobody worried much about the reset. That's because, historically, 70% or 80% of two-year hybrids were paid off in the first two years. Rising home values would reduce the loan-to-value ratio, qualifying the borrowers to refinance at lower rates. Or they would repair their credit and get a better loan. Or they would sell and move. Battling for market share, lenders didn't worry much about long-term consequences of lax lending.
But home values today are flat or falling. What's worse for many subprime borrowers, the escape route of refinancing at long-term rates is pretty much sealed off. The reason is simple: They can't qualify for a 30-year fixed-rate loan. Bloodied subprime lenders have belatedly tightened their lending standards. What's more, the rate on a fixed subprime loan is around 8.75%, which is higher than the teaser rate they've been paying. Sure, that's less than what they will soon be paying for their ARM, but they would have to apply to get a new fixed-rate loan and most couldn't demonstrate the ability to pay 8.75%. "They're going to be forced to stay with the adjusting portion of the loan," says Brian A. Simon, senior vice-president of Freedom Mortgage Corp. in Mount Laurel, N.J. "It's going to be a real challenge to a lot of borrowers."
Regulators allowed this problem to develop and only now are cracking down. On Mar. 2, five of them, including the Fed and the Federal Deposit Insurance Corp., came out for the seemingly obvious: requiring lenders to go by the uncapped interest rate--not just the teaser rate--in evaluating borrowers' ability to pay. But such tough rules will only worsen the squeeze on borrowers who need to refinance.
How big is the hit from rate jumps? A typical subprime loan might have been issued in early 2005 at 7% or so. Today, with its teaser expiring, that loan might be resetting to 10%, which is the most it's allowed to go up at one time. But the next time the loan resets--in six months or a year--the rate will go up again, based on the loan's contractual margin over LIBOR. So even if short-term rates stay where they are, ARM loans will approach 12% in the next year or so. That's way out of reach of most subprime borrowers.
For the Fed, the key question is whether the stress on subprime borrowers spreads to the rest of the financial system. So far, it really hasn't: Prime mortgage rates have actually been falling. So chances are the Fed will stay hawkish on inflation in spite of the harm to weak borrowers. Says Mark Gertler, a New York University economist: "I don't think the Fed is going to base monetary policy on distributional considerations. Once the Fed loses its focus on maintaining price stability, all hell could break loose." For many poor homeowners, it already has.
By Peter Coy