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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.

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