The Plan to Freeze Teaser Rates on Some Subprime Loans has Resistance from the Investors

How would you like it if you were a bond holder and Uncle Sam stepped in and unilaterally cut the interest rate on your bonds. What do you think your bonds will be worth going forward? When is the next time you would be willing to buy one of these bonds? How much faith will you have in bonds issued by private companies going forward?

Now assume that you pay all your bills on time. Furthermore, assume that you have an ARM and you have positioned yourself in such a way that you can continue to pay the mortgage when the ARM resets, after all that is the deal. Assume the guy across the street has exactly the same deal as you do in terms of ARM resets, price of home, and income, but he is basically a “screw-up” when it comes to handling his money. Because of a recent government policy his teaser rate is frozen, but yours is not. You acted responsibly and the guy across the street did not and you are being punished. How are you going to feel?

The question I have for Mr. Paulson is why are you meddling in the markets? Or are things so bad in the mortgage markets that if you do not meddle in the markets, the banking industry comes to its knees? Why does this sound like the 21st century version of FDR's "banking holiday" of the early 1930s?

I give - what am I not seeing.

See previous post on this issue. Text in bold is my emphasis. From the WSJ:

A government-led plan to freeze interest rates on certain troubled subprime home loans drew criticism both from investors who foresee losses and from some analysts warning that it will merely prolong the pain of the mortgage crisis.

As much as $362 billion in U.S. subprime home mortgages with adjustable interest rates are due to reset at potentially higher rates in the coming year, according to Banc of America Securities, risking a wave of defaults by borrowers unable to afford the new monthly payments. That in turn could exacerbate a wave of write-offs by investors who now own those mortgages. Losses related to bad mortgages already have reached the tens of billions of dollars and have led to turmoil in the world's financial markets.

Fears that the problems could accelerate have led the U.S. Treasury and the mortgage industry to develop a plan that would postpone the higher rates for some borrowers.

The success of the plan, details of which are still under discussion, may hang on the many investors in securities backed by mortgages. A coalition of lenders negotiating with the administration includes investor representatives, but the securities are held world-wide and it would be impossible to get everyone's approval. A deal could also spark lawsuits from investors who believe they're being cheated out of their money.

Unlike in years past, when just a bank and a borrower were involved in a mortgage, today's loans have been bundled together, sliced into securities and sold to investors. That has created problems for officials trying to help borrowers, because so many parties are involved.

Alan Fournier, a fund manager at Pennant Capital Management LLC, Chatham, N.J., predicted that the plan being pushed by the Treasury Department will prolong the pain of the housing slump. He said it would merely delay inevitable foreclosures for some people who can't afford their homes, while allowing holders of mortgage-backed securities to put off marking down their assets.

"This reduces the pressure short-term to bring everything to a clearing price," Mr. Fournier says. "We really just need to let it wash through."

Most subprime loans, which go to borrowers with poor credit records, carry an introductory "teaser" rate for two or three years before moving to a higher rate. The plan would keep the teaser rate temporarily for some borrowers.

The plan is being negotiated by the Treasury Department and a coalition of mortgage-industry participants, including lenders, mortgage counselors and servicers -- the companies that collect mortgage payments. Many of the particulars need to be worked out, including how long the interest-rate freeze would last and which subprime borrowers would be eligible for relief. . .

. . . . Still, the move is drawing criticism from some on Wall Street, who say the government shouldn't be meddling in the market.

"There's a part of this that's just morally repugnant. The problem is that the policy makers are talking to servicers about giving away other people's money," said Mark Adelson, a principal of Adelson & Jacob Consulting LLC, which consults on securitization and real-estate issues. "It's not the servicers' money, but shareholders' and investors' money."

Among those who stand to gain or lose the most in this plan are mortgage giants Fannie Mae and Freddie Mac. Their support would be crucial to the plan's success, because they are viewed as standard-setters in the mortgage industry. Both are members of the coalition. If they endorse the Treasury formula for loan modifications, that would make it easier for servicers to defend themselves from any challenges by disgruntled holders of securities backed by the loans being modified.

Freddie owns about $105.4 billion of securities backed by subprime mortgage loans, and Fannie holds about $42.4 billion of such securities, according to their third-quarter filings. Those combined holdings account for about 15% of the $1 trillion or so of U.S. subprime loans outstanding, according to trade publication Inside Mortgage Finance. Other holders of securities backed by subprime loans include banks, insurance companies, mutual funds and hedge funds.

"Fannie and Freddie have a lot more to gain than to lose" from a program that reduces defaults and foreclosures, said Moshe Orenbuch, an analyst at Credit Suisse in New York. If modified loan terms can prevent some foreclosures and delay others, that might buy time for the housing market to begin to recover, he said.

A temporary freeze on troubled home loans may help stave off defaults, a plus for investors in mortgage-backed securities, but it would also reduce the amount of interest the loans are expected to pay.

Investors' losses are likely to depend on what type of security they own. Some own riskier slices of debt that may lose much or all of their value if a home goes into foreclosure. This group might benefit from a plan that puts off foreclosures. Other investors might lose less from foreclosures, so long as the foreclosed house can be sold for a reasonable sum.

"The tricky part is that...you have these investors who are all spread out, people owning different bonds and all different classes and changing the loans may affect different classes in different ways," said Alex Pollock, a resident fellow at the conservative American Enterprise Institute and the former president of the Federal Home Loan Bank of Chicago.

The American Securitization Forum, which is part of the coalition and whose members issue, buy and rate securities backed by bundles of mortgages, had been resisting broad modifications of loans. Now it appears to be backing the idea of standard criteria that could be used to help large swaths of troubled borrowers.

"Currently, we are striving to develop streamlined methods of segmenting borrowers with various characteristics," said Tom Deutsch, the forum's deputy executive director, in testimony before a House hearing in California yesterday.

Peter Haveles, a partner at the law firm Arnold & Porter in New York, said the agreements underlying issues of mortgage securities generally give the servicers discretion to modify loans if they consider that to be in the best interest of the holders of the securities. He said the possible litigation isn't likely to derail the Treasury plan, in part because of the breadth of the coalition negotiating it.

A bill introduced by Rep. Mike Castle, a Delaware Republican, would temporarily free servicers from any liability for modifying loan terms. "Investors are still going to get a return and it's in their better interest to have those loans perform rather than fail," Mr. Castle said. (If lawsuits are not a big deal as indicated above then why is this needed.)