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Economics focus

Subprime solutions

Dec 6th 2007

From The Economist print edition

The promise and pitfalls of the Treasury's plan for mortgage-loan modifications

IS HANK PAULSON repairing America's mortgage markets or wrecking them? That question may sound churlish as the treasury secretary scrambles to stop the subprime mortgage mess dragging the economy into recession. But the palliatives that politicians produce today will shape tomorrow's system of mortgage finance. And with the Treasury now cajoling lenders into modifying whole swathes of subprime mortgages, policymakers are at something of a crossroads.

Mr Paulson's attitude to the subprime mess has, to put it charitably, evolved over the past few months. Half a year ago, he was firmly hands-off. The market should be left well alone, to shake out weak subprime borrowers and imprudent lenders. By the end of the summer, with credit markets in turmoil and Democratic politicians demanding help for beleaguered homeowners, Mr Paulson had changed tack. Prudent subprime borrowers—those who were in a house they might reasonably afford, but who had missed payments because their mortgages had reset to higher interest rates—should be brought into the orbit of government-sponsored lending by expanding the Federal Housing Administration (FHA), a Depression-era outfit that insures mortgages for poorer people. The initiative was modest; the direction was clear. The federal government would help a subset of subprime borrowers and use its own institutions to do so.

The Treasury has now embarked on a third approach. Worried that the avalanche of resetting subprime mortgages (some 2m in the next 18 months) would bring a surge of foreclosures and further weaken house prices, Mr Paulson has prodded lenders and mortgage servicers to come up with “an aggressive, systematic approach” to get “able” borrowers into modified loans.

The details of his proposal had not been announced as The Economist went to press. But the broad thrust was clear. Mortgage-holders would be divided into groups: those who could afford to pay their resetting mortgages (who would not get help); those who were in homes they plainly could not afford (who would not get help either); and in the middle those deserving borrowers who could service their loan, but not at the resetting rates. Some would refinance into mortgages under the government's umbrella; others ought to have their loans modified, probably by freezing the introductory interest rates for a period of five years. Mr Paulson has made it clear that his new strategy will not involve public money. This is less a bail-out than a soft cram-down (a reduction in the amount of debt owed to creditors). Subprime lenders are being coaxed into agreeing on a system for loan modification en masse.

The Treasury claims that the plan will produce winners all round. That is because the costs of foreclosure are high—typically around 25% of the value of the typical subprime mortgage. Lenders may take modest losses from, say, extending the period of lower interest payments yet still do better than if they pushed borrowers into foreclosure. But that begs an obvious question: if loan modification is such a win-win solution, why does the government need to get involved at all?

One reason to step in is that the Treasury solves a co-ordination problem. All lenders would be better off if a downward price spiral from unnecessary foreclosures could be prevented. Individually, however, each mortgage servicer might prefer foreclosing now, rather than waiting and possibly seeing the value of his asset fall. A second argument is that government involvement offers mortgage servicers some legal protection against investor lawsuits by, in effect, creating an industry standard for loan modification.

Home truths

But set against those gains are some risks. One is that the plan simply prolongs the subprime mess. Modifying a loan does not eliminate the risk of default later on, particularly when house prices are weak—and may become weaker still. Since the Paulson plan includes only a subset of borrowers, it will have a modest effect on overall foreclosures, and on resulting downward pressure on prices. And weak prices mean higher defaults: a new paper by economists at the Federal Reserve Bank of Boston suggests that defaults by subprime borrowers are extremely sensitive to home prices, far more so than to other shocks, such as losing a job. If prices continue to fall, in other words, loan modification simply puts off the inevitable.

A second worry is that the plan is a form (albeit a gentle one) of government meddling in private contracts, one that could have far-reaching consequences for investors' willingness to hold future subprime debt. America's debt markets will be permanently damaged if investors fear that government will simply change the rules to suit the times. Plenty of international evidence suggests that the depth of financial markets does indeed depend on the strength of creditor rights. For the moment, though, that worry is probably overblown. In spite of the moral suasion to sign up to an overall set of standards, there will be no explicit government compulsion to do so. Mortgage servicers will ultimately do what is in their investors' “best interest”.

All of which suggests the plan's impact will probably be modest. It may rationalise the process of dealing with interest-rate resets, but it will not change the contours of the subprime bust. That might mean more changes in government policy. Politicians will want more to be done to stop foreclosures rising in an election year. Pressure will build either for bail-outs (probably through greater use of government agencies such as the FHA) or for tougher cram-downs. Democrats in Congress, for instance, want to rewrite the personal bankruptcy laws to include mortgages among the liabilities that a judge can reduce. Mr Paulson has now stuck out a toe in both directions. The future of America's mortgage markets depends on which way he steps next.

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