Subprime Bailout Bonanza

The Subprime Bailout Bonanza

By David Gaffen | 8 December 2007

And so it begins. The bailout to end all bailouts, the drive to reroute traffic around this Big Dig-style snarl that’s engulfed the economy kicks off with President Bush’s speech outlining the plan. With further detail a better picture should emerge of the extent of government involvement in the markets on a level not seen since the resolution of the S&L crisis, and just what type of moral hazard is created for the future borrower, and what type of additional premium investors will ask for in exchange for the knowledge that such a wholesale restructuring of mortgage contracts could emerge as a result. Many cling to the assumption that the invisible hand that represents the markets is best served being left alone, but that was until the invisible hand started throttling the invisible neck of the economy. Be it a combination of government initiative, creative mortgage financing, too much easy money, bad Federal Reserve policy and predatory lending, here we are, and the invisible neck is gagging. After all, Lehman Brothers expects about 2.8 million subprime mortgages to reset in 2008 and 2009 about 30% higher.

[Left] Subprime delinquencies have soared, and upcoming resets mean more are expected (Source: Lehman Brothers).

The question that remains is whether intervention in these markets will produce a solution that will enhance the value of the vast supply of mortgages that are set to reset in coming years through loan modification. Nouriel Roubini of RGE Inc. supports the general plan, saying that investors in mortgage-backed securities, CDOs and other investments backed by this paper will see more return on their investment due to assistance provided to borrowers who can afford those teaser rates (not those set to default due to income problems or other inability to even pay the lower teaser rates).

"If you don’t do this scheme those investors are going to lose much more," he says. "The losses you’re going to have on CDOs and MBSs are going to be massive… the argument is just flawed. It’s the same thing as if you force a firm into bankruptcy liquidation— the value is going to be lower for creditors; the value is better when maintaining rather than destroying it."

But opponents of the plan argue that the default rates on many of these modified mortgages are extremely high— estimating in the range of 40% to 60%— and in an environment where the borrowers in question have little home equity (and therefore little incentive to hold onto the house) in properties where asset values are falling, the cost of postponing an eventual foreclosure and default is potentially greater to the holders of the loans.

"If home prices continue to decline [investors] may not really be getting more later," says Josh Rosner, managing director at Graham-Fisher, a housing and mortgage research consultancy. "Modified borrowers default at alarming rates."

The Calculated Risk blog suggests that concentrating the assistance to those with low FICO scores (around 660 or so) would limit the losses taken by investors. Rates wouldn’t adjust up to, say 10% or so, but investors would still get the 7.7% rate— as opposed to taking substantially lower rates if those with stronger credit were involved, and their mortgages were altered.

"The cost of this is, actually, going to be absorbed by investors in mortgage-backed securities," they write. "This is why ‘good credit’ borrowers are not going to be ‘rewarded’— because investors cannot be brought to forgo that much interest."

But some believe having mortgage investors bear that cost could result in an increase in mortgage rates in the years to come, as investors will need to factor in the possibility of another such occurrence.

"The lenders are getting a bad deal— if you keep these ARMs at the teaser rate, the overall return on the body of loans is going to be very inferior," says Christopher Whalen, president of Institutional Risk Analytics.

However, at least so far, the ABX indexes— which track a basket of subprime mortgages— haven’t budged all that much. The double-A rated ABX was traded at 39.8 cents on the dollar this morning, as investors still see very little value being recovered from those loans. "At the end of the day, the plan won’t have a huge impact," Derrick Wulf at Dwight Asset Management, told Dow Jones Newswires.
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