Investors Back the Bailout, Cautiously

Bondholders aren't exactly thrilled, but the surrender of some interest income now may help protect their principal later

Many investors take for granted that government should intervene as little as possible in the workings of the financial markets. Still, they are inclined to see the Bush Administration's decision to spare hundreds of thousands of mortgage holders (, 12/6/07) from higher rates as the best of several unpleasant alternatives.

The five-year rate freeze announced Dec. 6 will lighten the load for homeowners who took out adjustable rate mortgages over the last three years and face massive rate resets between January, 2008, and July, 2010. In many cases, those rates are scheduled to rise from the 7% to 9% range to the 11% to 13% range. On, say, a $300,000 mortgage, that could jack up monthly mortgage payments by $800 to $900.

To qualify for the rate freeze, homeowners must meet an exacting set of criteria: They must be no more than 60 days late on their loan. They can't have had more than 3% equity in the home when the loan was made. Their FICO credit rating score, named for benchmark developer Fair Isaac, can be no higher than 660.

Creating a Safety Net

By lowering anticipated interest payments, the plan will cut off a wave of revenue that was scheduled to flow into mortgage-backed securities. That alarmed credit-rating agencies such as Standard & Poor's, which warned on Thursday that the ratings of some mortgage-backed securities could fall (, 11/8/07) as a result of the bailout. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).)

For the most part, investors appear willing to accept lower interest payments in exchange for some reassurance their entire investment in lenders or mortgage-backed securities won't be wiped out. In other words, the alternative to reduced interest income could have been a total loss of principal on some investments. "There is a serious problem with delinquencies over the next few years. Without action, many bondholders may not have gotten their principal. Now they have a better chance of getting paid back," says Joseph LaVorgna, chief U.S. economist at Deutsche Bank (DB).

Equity investors seem to accept the necessity of the bailout as well. "There will be some protection for investors. With this plan, the risk of a particular company going bankrupt is lower," says Bob Doll, global chief investment officer for equities at asset manager BlackRock (BLK). "It is creating some safety net. These are steps in the right direction." Doll is on the hunt for shares of beaten-down financial firms that may have a good chance of bouncing back.

Stemming the Tide of Delinquencies

There are bound to be some disruptions as a result of such large-scale government tinkering with the financial markets. Lisa Nelson, vice-president for scoring solutions at Fair Isaac, says lenders are nervous investors will be scared away from the mortgage-backed securities market, making it harder for lenders to sell their loans. That could limit the money available for future lending.

But the alternative appeared to be much worse. The prospect of higher delinquency rates and a greater risk of recession (, 11/19/07) scared the markets more than the uncertainties of government intervention. There's no guarantee the worst outcome can be avoided. But coupled with lower interest rates, investors seem to think they have a fighting chance.

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