Friday, December 14, 2007

The Plan to Freeze ARM Rates

The Bush administration recently announced a plan that would allow the interest rate on some sub-prime adjustable rate mortgages (ARMs) to be refinanced or frozen for five years. Like so many things this administration does, the plan is based on unfounded hopes, and the consequences have not been thoroughly evaluated.

In the next two and a half years, the interest rate on as many as 1.8 million sub-prime owner-occupied ARMs will increase. The Bush administration estimates that nearly two-thirds of those borrowers were able make their payments with the low introductory interest rate, but will be unable to afford the increased rate.

Under the administration’s proposal, only borrowers with FICO scores under 660 who face an increase in monthly payments of greater than 10% will be eligible for the program. Borrowers who are behind on their payments, who have other mortgages that prevent renegotiation of the ARM, and borrowers with ARMs that have already increased from the initial “teaser” interest rate will not benefit.

The plan is supported by the American Securitization Forum, the companies that issue mortgage backed securities, as well as investors and loan servicers.

Consumer advocates and Standard and Poor’s rating agency are skeptical.

The administration estimates the program will provide debt relief for up to 1.2 million borrowers. The Center for Responsible Lending (CRL) states that perhaps only 145,000 borrowers will qualify. CRL notes that the plan is only a set of voluntary guidelines for mortgage servicers. If lenders decide that will be more advantageous to them to foreclose, they are under no obligation to renegotiate home loans.

In this market, I don’t think lenders will be eager to foreclose and take possession of houses with negative equity. However, lenders will be concerned about lawsuits from the investors who bought these mortgages with the expectation that the interest rate will increase to a profitable level within the next two years.

Standard and Poor’s stated that freezing interest rates on ARMs could discourage investment in mortgage backed securities, which will make the home loan credit crunch worse.

I think this idea is short-sighted grandstanding. It just delays the inevitable. Wage increases have not kept up with inflation, and it’s unlikely that trend will reverse within the next five years. If borrowers are unable to absorb a few hundred dollars increase in their mortgage payment now, it is unlikely they will be able to afford the increase five years from now.

The other big problem with this plan is that it is so unfair to the millions of people who don’t meet its very narrow guidelines.

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