December 6, 2007
I've been putting some thought into the subprime mortgage market debacle (a.k.a. "credit crisis") and here's what I've come up with.
Fueled by misleading advertising, agressive mortgage brokers, and over confidence in the housing market, many borrowers with shakey credit are finding themselves in dire financial straits.
The economist in me says "don't sweat it", the market will work itself out. Interest rates go up, people get foreclosed on and become renters. The banks/lenders/funds that overly invested in the risky policies will be forced to sell these homes at spiralling prices and will lose money on their investment. That's why they call it risk.
But what about the people who get forced out of their homes? As much as part of me wants to punish people for signing contracts in these investment vehicles that are so incredibly beyond their means, I shudder at the effects this will have on the entire housing market and just-about-everyone's nest egg.
The bailout effort mentioned earlier today takes it too far by freezing the rates on ARM products. Why should all of these people who "mortgaged their future" get a free pass for the next 5 years? Unless they can prove predatory lending, they bought more than they can handle and should not be rewarded with getting to pay "teaser" interest rates for the next 5 years.
To be clear, the only real problem is that the interest rates on these ARMs is going up higher and faster than the borrowers expected and their monthly mortgage payment is becoming more than they can afford.
Part 1 - Triage Convert subprime ARMs and Interest Only loans that begin adjustment phase prior to January 1, 2009 to 30-year fixed subprime loans. Lenders won't like this because teaser rates are, in all honesty, a pricing model used to attract people to their product. They make less money early in the loan so that they can make more money later. However, the fixed rate loans have interst rates that already take the risk-reward into account and should hold their value and lenders ought to be receptive to the idea of "paying a little" to gain some stability in the housing market.
This conversion would be automatic. Borrowers who want to keep their ARM would have to submit an "opt out" statement within 90 days.
Part 2 - Prevention Enact legislation that caps the "monthly mortgage payment" on subprime loans to a maximum percentage (e.g., 40%) of the borrower's stated income. This measure prevents lenders from signing up borrower's into loan products that the borrower cannot be reasonably expected to pay back.
Any time the market indicates an interest rate above the threshold, the lender loses some revenue. To compensate for this, the lenders could raise the teaser rate to recoup this revenue earlier in the life of the loan. This, in turn, will make these loan products less desirable and "questionable" borrowers will do what they should have been doing all along - renting.