While the Bush Administration's plan to freeze interest rates on subprime ARMs generated talk of potential investor litigation, its expected limited impact could eliminate the possibility of a moral hazard, sources say.
It is too early, of course, to gauge the full effect of Treasury Secretary Henry Paulson's rate freeze plan. But analysts said that limits to loan modifications were not only built into Paulson's plan, but also within the mortgage servicer's own contract.
"A moral hazard is beside the point," said Michael Youngblood, managing director of fixed-income research for Friedman, Billings, Ramsey & Co. "It has been made clear that the servicer's paramount responsibility is upholding the servicing and pooling agreement. What this policy does is gives them some credible rules to work through their servicing portfolio, rather than have them guessing."
Paulson's plan calls for a five-year freeze in loan rates for certain subprime mortgages. President Bush has said that up to 1.2 million people will be eligible for assistance, although according to reports, only a fraction will actually qualify for the rate freeze. Other borrowers will be able to refinance existing loans into new private mortgages or have them moved into an FHASecure loan.
According to Youngblood, about half of the subprime borrowers will be able to refinance their loans into an FHASecure, Freddie Mac or Fannie Mae loan, rather than seeking out a modification. "If you could refinance into a Fannie or Freddie conforming loan, why would any rational borrower not do this?" he asked. "The moral hazard is going to be trumped by the ability to refinance."
James Grady, structured finance senior portfolio manager for structured finance securities at Deutsche Asset Management, noted the risk of any bailout plan lies in the possibility of creating an incentive to repeat mistakes. "The moral hazard would be that by rescuing borrowers that got in over their heads it would lead others to make decisions in the future with the expectation that someone will come up with a rescue package if something goes bad," he said.
But, he added, today's beleaguered market does not offer opportunities for the same questionable transactions that drove the housing boom. "Capital stopped flowing into the sector because investors have been burned, so the opportunity [for existing borrowers] to make the same mistakes is arguably not going to be there in the future."
Beyond the question of whether Paulson's plan creates a moral hazard, is the question of whether the program will even work at all. Speaking during a fixed-income conference call on Dec. 12, Andy Chow, structured products portfolio manager for SCM Advisors, said "Most of the people that are going to be allowed to participate in the program are people we think are going to default anyway."
Chow added that the threat of potential investor litigation has slowed the loan modification process in the past. Because the default will be delayed, Chow said, the investor is subject to the home price fluctuations over a longer period of time in. "This greater variability in terms of recovery value means that there is a greater volatility in the overall recovery value of the pool of mortgages," he said.
Whether the risk is real or perceived, Deutsche's Grady said, it is important to keep investors in mind while trying to assist troubled borrowers. "It's very important to strike a delicate balance between borrowers and investors," he said. "It's in nobody's best interests for investors to feel like the rules of the game have been changed on them mid-cycle because that could stop the flow of capital and have a negative impact on the economy as a whole."
Ultimately, Grady questions the potential impact the rate freeze will have on the overall market. He noted that the delinquency levels for 2006-07 vintage loans are over 20% and these haven't even reset yet. The bigger problem, he said, stems from borrowers that have taken on bigger loans than they can handle, not from the resets.
Paulson's plan will also be limited enough so as not to constitute a massive bailout. "It's important to help borrowers that are able to make their current payments but would end up defaulting upon a reset in a way that doesn't result in a free handout," Grady said. "But we don't view this as having a meaningful impact."
FBR's Youngblood said it is important to remember that modifications for non-subprime loans have been a dominant industry practice for well over a decade. While he acknowledged that "we live in a litigious society," he does not foresee the majority of investors bemoaning Paulson's plan as a moral hazard. "There is that militant minority of investors that care solely about the ABX Index instead of the performance of a subprime security generally," Youngblood said. "But I don't think investors are negatively impacted."
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