Barney Frank's 'Subprime Relief Plan' May Make a Bad Situation Worse

If I understand its terms right—and I think I do—Barney Frank’s ballyhooed $300 billion plan to stem subprime foreclosures figures to take a bad situation and make it even worse. Reason: the plan would give up-to-date borrowers a powerful incentive go delinquent on their loans, perhaps on a massive scale. This is supposed to help fix the problem?

There’s no way of knowing what the final bill will look like, or course—or even whether any mortgage relief plan will pass at all. But as it’s written now, here’s how the Frank plan would work. The holder of a delinquent subprime mortgage would take a writedown on the loan, then dispose of its loan in a short sale funded by the issuance of a smaller, government-guaranteed FHA loan. In return, the holder escapes further credit risk. Fine. The specific size of the loan writedown, though, would depend on the size of the new FHA loan, which in turn would be set according to terms “the borrower can reasonably be expected to pay.” In particular, the maximum allowed loan-to-value ratio of the new mortgage would be 90%. Notably, the process would be initiated by the borrower or the loan servicer.

As I say, if the government has ever before put in place such a powerful inducement for wholesale borrower delinquency, I can’t recall it. Let’s walk through some numbers and you’ll see what I mean.

Neighbors A and B

Take two neighbors, who both took out 0%-down, $300,000 ARMs, each with a 5% introductory rate, in mid-2006. Since then, the houses they bought have fallen by 10% in value, to $270,000. At reset (which will happen any month now, to around 8%) their monthly payment will rise to $2,000 from the current $1,250.

OK so far? The only difference between our two borrowers is that Borrower A is current on his loan, while Borrower B is delinquent, and so qualifies for relief under the Frank plan.

And, indeed, Mr. B applies for relief. His new, FHA-funded loan comes to just $243,000—90% of his home’s $270,000 appraised value—so his monthly nut (at the same 8% he would’ve been paying under the terms of the old loan) is now just $1,620. Still-current Borrower A, recall, is paying $2,000 per month, after reset, for the identical house. Oh, and Borrower B now has $27,000 of equity in his home, while A is upside down by $30,000.

What do you suppose the Borrower As of the country would do at this point? I’ll tell you one thing: a lot of them would go delinquent on their mortgages on purpose, to qualify for the same sweet deal that the Borrower Bs have gotten.

Boom—a new leg down in the subprime mortgage crisis!

Two million, and counting

And the numbers wouldn’t be small, either. Frank himself sees something like $300 billion in new FHA loan issuance under the plan, to up to 2 million households. And that’s if everybody plays by the rules. Once you add in people who fall behind on purpose (which won’t be a few, trust me), the number of new bad loans could skyrocket.

You might object at this point, and say that that Congressman Frank has built safeguards into his bill—like, say, insisting on a government claim on any subsequent home-price appreciation--to prevent intentional delinquency from happening. You would be mistaken. Sure, the feds would have a claim on any gains the borrower realizes after a sale. But the size of that claim declines the longer the borrower stays in the house, and falls to zero after year five in any event. In the meantime, the borrower gets an immediate $57,000 boost in his equity, to $27,000 from minus-$30,000.

Similarly, to prevent abuse the Frank plan requires that borrowers must have had mortgage debt-to-income ratio of at least 40% at March 1, 2008. But as the press release that accompanied the bill notes, “regulators can make exceptions for involuntary changes after that date.” So there’s discretion and wiggle room.

In all, it’s very likely that the bill, if enacted in its current form, would end up doing more harm than good. I’m all for finding ways to help overstretched borrowers. But it’s crazy to consider any “solution” that figures to take a bad situation and make it even worse.

Tom Brown is head of BankStocks.com.

Comments

[Jack K:]

Socialists like Frank think they can change laws of economics by passing statutes. He is a joke, but the liberals from Massachusetts keep electing him.

2008 Apr 13 08:44 AM

[Igneous:]

An excellent write-up Tom. Hopefully some elected officials will read it and re-think. Is that possible?

2008 Apr 13 09:12 AM

[lindlou:]

Possible that they actually read or think? I'm doubtful.

2008 Apr 13 09:27 AM

[Rich4REITs:]

This plan is greater than Mission Impossible at all! How come they can prevent and fake document of debt-to-income again? Who gonna issue the values of borrowers' houses on March 1, 2008? In the end, whose money to support the FHA loan? Frank? Uncle Ben? or the public??????

2008 Apr 13 10:16 AM

[Looch:]

Excellent portrayal of the economic consequences of moral hazard.
I closed on an 80/15 wiht Countrywide (a 1/5 fully amortizing ARM) last in July of 2007.
My LTV then was a 95% and I guarantee you ha tit is about 110% today. But as long as I can afford to pay I will or I'll refinance or sell when the market is more favarable, regardless of Barney ball.

2008 Apr 13 02:39 PM

[mallarde:]

If all these "homeowners" got a windfall gain like those that bought a year before them, would they have shared their profits with U.S. taxpayers? If not, why should we be forced to share their losses?

Something tells me none of these horrible bills will pass because a lot of taxpayers are watching and getting irritated by the prospect of bailing out speculators.

2008 Apr 13 04:28 PM

[pochovilla:]

The real problem here it is unlikely the appraisal will be as high as $270,000 particularly in the late stages of the process when appraisals got pumped to produce more fee income. California is a particular problem where anecdotal evidence suggests 20%+ losses in certain markets.

2008 Apr 13 10:28 PM

[Underwater:]

THIS WHOLE ARTICLE IS WRONG!

First, the bill (as it was written now) does not require you to even be deliquent - only to have a debt to income ratio of 40% or higher

AS OF MARCH 1st, 2008.

So you can't just "go deliquent" as the article suggests. The bill sets a specific date in which you must have met specific financial conditions. This article is bogus.

2008 Apr 14 05:21 PM

[IDROJ:]

Do you know if they will do the same with cars, I want to buy a Porsche and I don't have enough money, If a buy it now and I can't pay later can I get my a write-down in my loan?

2008 Apr 14 06:35 PM

[dbulkley:]

When the foreclosed move into rentals they'll be paying much less in rent. To address the 'blight' problem bemoaned by bailout proponents, simply have the Fed fund lawn mowing and graffiti removal - that will be 50x to 100x less than the mortgage rescue plan.

2008 Apr 14 10:34 PM

[Ames Tiedeman:]

There is nothing the government can or should do. Home prices may be as much as 50% over priced in many areas. This is bubble that has only begun to burst. The Congress cannot fix this. They were too stupid to pass laws about who qualifies for a loan so why do you think these idiots can fix this mess now? It will be 10 years before this is over..

2008 Apr 15 08:05 AM

[johngonole:]

Prices must be allowed to fall. High land prices make farming uneconomical. It has also caused many of them to sell their land. We are already seeing the consequences of this economic distortion. We could be setting up a world wide famine for people in many places. This will lead to blood being spilt all over the world. The #^%#& bankers and FED knew this was happening all along. The policy of total recession avoidment for political gain has caused the bubbles. Its time "We the people" put a stop to facism and abolish the Federal Reserve. The FED claims they bring stability to the banking system but in reality the instability is worse only they mask it with inflation tax and tax payer bailouts. Those of us who are wisest and make the best decisions should control investments in this country not the bankers. Someone should create a person to person lending platform with all the legal paperwork and completely cut the bank out of the loop. The same platform could administer contract and arbitration enforcement. I doubt people would make risky loans with their own money. If they did shame on them. Lets take responsibility for ourselves again in this country. Lets go back to lending to people we know on a personal level. The investment houses, banks, oh yeah and the government are stealing our life's work via inflation, bail outs, etc...

My generation possibly faces a life time of work with nothing left at the end of it and zero finanical security.

2008 Apr 16 01:40 AM

[edward54:]

Excellent article. I think it's better for Congress to allow the regular process to work. We got into this mess because some in Congress wanted lax lending standards to expand American homeownership. So they got their wish. Let them see the consequences.

2008 Apr 24 03:26 PM