Uncle Subprime

April 3, 2008

Mortgage foreclosures haven't yet hit their peak, it's an election year, and Congress is back in session. Hold onto your wallets because a housing bailout is moving forward unless the White House says no.

Senators from both parties agreed late yesterday to throw about $11 billion more at the housing market, and we'll have more to say about that later. But think of Uncle Sam as the subprime lender of last resort and you are getting close to what the Beltway is contemplating. In the name of preventing foreclosures, House Financial Services Chairman Barney Frank wants to transfer the risk of further declines in home prices to taxpayers from lenders and borrowers.

Mr. Frank's idea is that, for mortgages originated between the start of 2005 and mid-2007, a lender and borrower would be able to agree on a federal refinancing plan. Lenders would have to write down their loan to no more than 85% of the current appraised value of the property – which means the banks will use this opportunity to unload the biggest stinkers in their loan portfolios.

For the borrower, the deal is even sweeter: a low fixed monthly payment and a reduction in the principal to market value. The Federal Housing Administration would then guarantee the loan, up to a total of $300 billion in total Frank Refis. The deal is so sweet that even Mr. Frank is concerned that otherwise reliable borrowers may "purposely default" to be eligible for assistance. His solution is to require borrowers to "certify" that they really, truly aren't doing this simply to get on the taxpayer gravy train.

The pols also understand, but won't admit, that you can't bail out borrowers without bailing out lenders. And on both counts, we're not talking about the most deserving recipients in the history of welfare: Those receiving bailouts will be lenders who chased high returns despite the risks, and borrowers challenging historic rates of delinquency even before rate resets. Many will also be fraudsters, given that mortgage fraud has increased more than 1,200% since 2000.

A new study from the Boston Federal Reserve destroys the myth of the victimized subprime borrower. Boston Fed economists examined 1.5 million homeownerships over nearly 20 years and found that the overwhelming reason for subprime foreclosures is not unsustainable debt foisted on ignorant borrowers or even financial setbacks. People walk out on subprime mortgages when the value of their home declines.

Homeowners who've suffered a 20% decline in home prices are 14 times as likely to default as those who have enjoyed a 20% gain. "Subprime lending played a role but that role was in creating a class of homeowners who were particularly sensitive to declining house price appreciation, rather than, as is commonly believed, by placing people in inherently problematic mortgages," says the Boston Fed study. In other words, even if the government moves these borrowers into FHA-guaranteed mortgages with fixed rates, but home prices keep falling, lots of borrowers will stiff the taxpayers like they've been stiffing private lenders.

Traditionally, lenders making a commitment to finance your home have demanded that you make a commitment as well: a down payment. But during the credit boom, the shrinking market share of FHA-insured loans demonstrated how much the world was changing. FHA was intended to help moderate-income borrowers afford homes by requiring merely a 3% down payment. When subprime lenders started offering loans with zero down, FHA asked Congress to let their lenders do the same. Fortunately for taxpayers, Congress resisted. In the fourth quarter of 2007, FHA loans were one mortgage category that actually enjoyed a decline in foreclosures.

That trend may not last, because Mr. Frank's bill waters down FHA underwriting standards. Today, the FHA tells lenders that a borrower should not have debt payments amounting to more than 43% of monthly income, but Mr. Frank's bill allows this figure to rise as high as 55%.

Under current FHA guidelines, lenders must also closely examine a borrower's credit history. Yet under the "flexible underwriting standards" in Mr. Frank's draft, borrowers can't be denied FHA insurance due to a low credit score. Delinquency on existing mortgages also can't be the sole reason to deny FHA insurance. Mr. Frank's bill authorizes the Secretary of Housing and Urban Development to contract out for a new underwriting system, and it should be entertaining to see what HUD's political minds can devise to appease pressure groups.

In sum, Mr. Frank is volunteering U.S. taxpayers to insure $300 billion in mortgages with underwriting standards to be named later. Connecticut Senator Chris Dodd thinks $400 billion is more like it. Quavering Republicans should do the political math. The Mortgage Bankers Association tracks 46 million mortgage borrowers, and 42 million are paying on time. More than 20 million households own their homes outright and, having worked for years to pay for them, probably don't want to pay for someone else's. Neither do 35 million renters who didn't take a flyer on nicer digs.

The good news is that a taxpayer champion is emerging from, of all places, Florida. His state is ground zero in the housing downturn, but House Republican Tom Feeney says, "My constituents are not terribly sympathetic with borrowers who made bad decisions." We're told the White House will oppose the Frank-Dodd bailout, but if there's any doubt, Mr. Bush should have Mr. Feeney in for a chat.

The lead editorial column in today's Wall Street JournalSee all of today's editorials and op-eds, plus video commentary, on Opinion Journal.

[As always, Ray Kutylo and the SCV Home Team view macro-economic decisions as well outside of our authority to influence. However, we are all influenced by these decisions in both our personal and business environments. Public policy, either good or bad, will have far-reaching effects. We pay attention to these currents and changes in directions of public policy in order to better advise our clients.]