In her testimony before the House Banking Committee last Thursday, FDIC Chairman Sheila Bair listed some "misconceptions" about the subprime mortgage loan restructuring program she's been pushing (converting 2/28 and 3/27 ARMs into 28- or 27-year fixed rate loans using the teaser rate). Let's briefly fisk review them and her responses:
Misconception: Restructuring Will Create a Windfall for Subprime Borrowers.
Ms. Bair argues that "[t]his misconception is based on the belief that the starter rates for these loans are similar to the low 1 to 2 percent 'teaser' rates that were aggressively advertised for prime borrowers. In fact, of subprime hybrid mortgages originated in 2006, the average starter rate was 8.29 percent, which exceeded the average rate on subprime fixed rate loans made in that same year (8.06 percent), and was well above rates paid on prime fixed rate loans. These subprime borrowers will continue to pay higher subprime rates even after restructuring."
The definition of a "windfall": A sudden, unexpected piece of good fortune or personal gain. The borrowers will receive "a sudden, unexpected piece of good fortune and personal gain " because they will not pay the much higher rate required by the loan documents as originally agreed to by borrower and lender or, in the alternative, lose their home to foreclosure. Whether or not it's a "windfall" has nothing to do with whether the teaser rate is 1% or 8.29%. The consequences of the loan restructuring would constitute an unexpected gain. Did Ms. Bair deliberately mischaracterized the "basis" for the viewpoint, or she doesn't understand the basis of the viewpoint? You be the judge.
Misconception: Restructuring Will Deny Investors Their Expected Return
Ms. Bair characterizes "expected return" as the receipt of interest after the commencement of the first interest rate reset. She then makes the questionable assertion that the loans were "never designed" to extend beyond the teaser rate term (2 or 3 years) because the gap between the teaser rate and the initial expected reset rate was "so high." Accepting Ms. Bair's argument at face value (which I do not), it contradicts itself. If the program was not designed to last beyond the reset period, then each investor that purchased a tranche of the collateralized debt obligation that is secured by such a loan must have paid a price based upon the expectation that the investor would receive repayment of the full principal at par at the end of the teaser rate period, at which point the investor would reinvest the principal. The investor would have required a different (likely, much higher) rate of return if his or her principal was to be committed for a longer period of time, perhaps the reset rate, or perhaps a higher rate. Whatever that rate, Ms. Bair's proposal would require the investor to accept the teaser rate for a much longer period of time than she states the program was designed to accomodate. Therefore, the investor is not receiving his expected rate of return under Ms. Bair's patently flawed argument.
Does Ms. Bair understand the subprime mortgage market market or, even, basic principles of mortgage finance and asset securitization? Does she understand but is attempting to deliberately set up misleading straw men in order to have something to knock down? You be the judge.
Misconception: Restructuring Just Delays Eventual Default
Ms. Bair's proposal assumes that the teaser rate would become the fixed rate for the remaining term of the loan (27 or 28 years). On that basis, her argument that those borrowers who have been paying at the teaser rate will likely continue to pay at the teaser rate is correct. It is also misleading. Critics who make the argument that extending the teaser rate for a short period of time merely delays the inevitable (labeled a "misconception" by Ms. Bair) are criticizing proposals (embodied in the "Hope Now" plan announced by Treasury Secretary Paulson) that extend the teaser rate for a limited period of time, i.e., five years, at which time the much higher reset rate will be effected. They may dislike Ms. Bair's proposal on other grounds, but not this one. Ms. Bair takes an argument that addresses apples and attempts to apply it to her orange. Another straw man set up and knocked down by Ms. Bair.
Misconception: Restructuring is Unnecessary Based on Past Levels of Credit Losses
Ms. Bair makes the assertion that past default rates do not offer a valid guide to current expected default rates. I don't disagree. However, any speculations that we make about future events where the past is not a guide are just those: speculations. Who's better qualified to make those speculations if the past is not prelude to the future: people with skin in the game and actual industry experience or political hacks, bureaucrats, former academics, and avowed consumer advocates? That's a question of personal judgment, but I know where my preferences lie. If Ms. Bair is correct in her assertions that we are headed for a tsunami of foreclosures unless loan servicers engage in "across-the-board" loan modifications of all 2/28 and 3/27 loans at the teaser rate, why does she has support (along with other bank regulators) a plan to modify only loans secured by "owner occupied properties where the borrowers are current on their payments"? How will that limited plan address the much higher default rates that she asserts will occur? She doesn't say.
Misconception: Standardized Loan Restructuring Cannot Be Accomplished on a Wide Basis
Ms. Bair again mischaracterizes the argument of her critics, which is not that the widespread modifications "can not" be done, but, rather, that they "should not" be done. Ms. Bair states that certain loan servicers (who she refuses to name) are already implementing wide-spread loan modifications. It's not difficult to argue that an across-the-board loan modification program might be easier and quicker to implement than a loan-by-loan analysis, but can a loan-by-loan analysis be avoided? Critics argue that that even if it can, this is unwise from a public policy and/or long-term financial standpoint, and that it may subject servicers to legal liability risk that outweighs the potential financial benefit that may result. Ms. Bair asserts in her testimony that her plan protects servicers by yielding the maximum net present value from the loans, on an aggregate pool basis. Buried in a footnote of her testimony is this guidance from the American Securitization Forum: "The
ASF believes that loan modifications meeting the criteria in Loan
Modification Principles point 4 above are generally preferable to
foreclosure where the servicer concludes that the net present value of
the payments on the loan as modified is likely to be greater than the
anticipated net recovery that would result from foreclosure." In other words, the servicer has to make the determination as to what's in the best interests of the bond holders in the aggregate by doing a net present value calculation of foreclosure and its alternatives on a loan-by-loan basis. Yep, a streamlined process, for sure.
Toward the end of her speech, Ms. Bair returns to her oft-stated pro-consumer argument, reworked with a "what's best for servicers and investors" spin:
Finally, I would note that brief extensions of the starter rate will not provide stability to the borrower, investors, or the market. Brief extensions simply increase the resource stress on servicers and decrease the ability of the market to determine market prices for mortgage assets.
A few paragraphs later, she gives additional "final" comments:
Finally, I would like to pay tribute to Treasury Secretary Paulson's leadership in advocating systematic, sustainable loan modifications. Through the Treasury-led Hope Now effort, I am optimistic that national agreements on systematic loan modifications, combined with reporting templates for effective monitoring, are coming to fruition.
The Hope Now plan calls for a 5-year extension of the teaser rate. Is five years not "brief"? She "pays tribute" to a limited extension plan when she's insisted for months that a permanent extension is the only workable solution. Inconsistent? Hypocritical? Nonsensical? You be the judge.
