The rate-freeze plan announced by the Administration will probably be of some help, but will have little or no effect on heading off a recession or preventing the housing situation from worsening. To the extent that it works, the plan will reduce somewhat both the number of future foreclosures and the supply of additional houses coming onto the market. The problem, however, is that the plan has limited goals, and the current situation is already a disaster even before the scheduled resets take place. Overall it’s a classic case of the barn door being closed after most if not all of the horses have run away.
The major problem that is belatedly panicking the various authorities is that about two million subprime adjustable-rate mortgages are due to be reset over the next two years with the average monthly increase in payments estimated at between $300 and $350 A large number of these mortgages are held by people who can’t afford to make the new higher payments. In the absence of any action they will default and be subject to foreclosure proceedings that will result in their houses being taken over by lenders for sale into an already saturated market. This would come on top of the current turmoil in the credit markets and the already softening economy.
The plan basically calls for a five-year freeze of certain teaser rates on subprime mortgages taken out between 2005 and July 30, 2007 with rates scheduled to rise between January 1, 2008 and July 31, 2010. The freeze would apply only to those who are presently current on their mortgage payments and have 3% or less equity in their homes, but would not be able to make the higher payment following the reset. It would therefore exclude those who are already in default and those who are deemed able to make the higher payments. Also excluded are mortgages due for reset in the current quarter. In addition Representative Barney Frank says that Secretary Paulson has confirmed to him by phone that those with credit scores above 660 will have a heavier burden of getting help under the plan.
Given these rules the plan is somewhat limited in scope. It is estimated that 22% of all subprime borrowers are already in default, making them ineligible for help. An additional $57 billion of mortgages due for reset in the current quarter are also ineligible. After further subtracting those able to make the higher payments, Barclay’s Capital estimates that only about 12% of subprime borrowers would be get relief. Although other estimates run a bit higher it seems clear that the number of people getting help is not enough to change the dire macro economic outlook by very much. Nicolas Retsinas, director of Harvard University’s Joint Center for Housing Studies said the plan may help about 15-to-20% of all subprime borrowers. He stated "It is an important band-aid but the arm is hemorrhaging."
Let’s not forget that the current problems with subprime mortgages were not caused by resets but by the fact that a large percentage of subprime mortgage holders can’t even afford the teaser rates. Foreclosures were already at a record high in the third quarter. Subprime adjustable rate mortgages showed a foreclosure rate of 4.7% while 18.8% were over 30 days late in payments. A large percentage of late-payment mortgages end up going into forclosure. In addition the housing industry is in plenty of trouble before most of the resets are due to take place. Existing home sales are down 21% year-over-year and inventories amount to 10.8 months of supply. Prices are down 5.1% from a year ago and still declining. A new study by Morgan Stanley, based on past regional home price declines, sees substantial risk that home prices will fall for the next three years or more ".given the tremendous overhang of subprime pressures, risk of recession, and the high cross-regional correlations."
New credit problems continue to emerge almost every day. The ratings agencies are still in the process of lowering credit grades of billions if not hundreds of billions of dollars of various securities. Moody’s says that bond insurer MBIA could be downgraded without an infusion of capital. Hundreds of billions of dollars of bonds owe their triple-A ratings to guarantees by MBIA. Auto loan delinquencies are also rising sharply. 4.5% of prime-rated auto loans made in 2006 are delinquent, the most in eight years. 12% of all subprime auto loans are also delinquent.
All in all we think that the rate freeze plan will keep some additional families in their homes and avoid some foreclosures that would otherwise take place. However, it is far too late to stop the downward housing spiral and a softening economy that appears headed for a recession. It is highly likely that the current market rally is just a bear market reaction to the announcement of the freeze plan and the prospect of a Fed rate cut next week. Let’s keep in mind, though, the highly negative reasons for the panicky Administration response to the coming mortgage rate resets and the Fed’s alarm at the current credit and economic outlook.
