Paulson Promoting Rescue Program for Subprimes

Do we see a pattern here? The much-covered, little-loved SIV rescue program (formally known as the Master Liquidity Enhancement Conduit and informally called the Entity or Super SIV) was announced prematurely, didn’t clearly solve the problem it was meant to address, involved a lot of failing around to try to resolve irreconcilable interests (those of the SIV sponsors versus the investors who would eventually fund it) and appears to be stillborn (despite the expectation that a structure would have been announced and syndication of the credit enhancement would be underway, we’ve heard nada, presumably because HSBC’s decision to rescue its own troubled SIVs has put a damper on the MLEC plan).

Paulson seems unable to learn from his own experience. He is swinging for the fences with another Big Scheme That (Purports To) Fix The Problem With A Master Stroke. His track record here is not encouraging.

According to Bloomberg, he had a one hour meeting today:

…. with federal regulators, bankers and lobbyists. Executives of Citigroup Inc., Wells Fargo & Co. and Washington Mutual Inc. attended, said a person present….

“One of the roles of Treasury is to say `come on, let’s get together and see what we can do,”’ said Wayne Abernathy, executive director of financial-institutions policy at the American Bankers Association in Washington and a former Treasury assistant secretary. “You’re likely to come up with something that will work both in the marketplace and honor the sanctity of the contracts involved.”

This was effectively a kickoff meeting to bring relevant parties together to discuss possible approaches to the subprime mess. Yet how is this treated in the Wall Street Journal? It’s a page one story, “U.S., Banks Near A Plan to Freeze Subprime Rates.” And in more MLEC deja vu, we have the too often repeated mantra,

Details of the plan, which could be announced as early as next week, are still being worked out.

Now either Bloomberg is wrong, or the Journal is wrong, but that telltale sentence says the Treasury has again let the press get too far out in front of the story.

Of course, unlike the MLEC plan, there is a precedent of sorts here that could serve as a blueprint for the Federal effort. In California, four mortgage sevicers have agreed to extend teaser rates for certain borrowers for five years. However, there has been a remarkable lack of detail about how this will work or how many people it will help. Borrowers have to be current on their payments and they need to “prove” that a rate increase is beyond their means. We have seen that state programs to salvage troubled borrowers have achieved very little in the way of tangible results. The California program may fall into the same camp.

Ironically, if the California plan and any state or federal programs along similar lines do help a lot of borrowers, they could run into a second set of problems: investor lawsuits. It isn’t at all clear that the servicers can enter into loan modifications like this unless they will help, or at least not hurt, the investors. It’s hard to establish that with blanket programs, which is what these are intended to be. Remember, the servicers have no legal obligation to the borrower beyond those specified in the mortgage, and those agreements are pretty one-sided. We’ve gone on at greater length elsewhere why we regard the “fix the initial rate” concept as problematic. Indeed, as the Bloomberg story points out,

Mortgage-industry lobbyists have argued an across-the-board solution is difficult to apply. Rewriting contracts also risks moral hazard — encouraging borrowers to take on more debt in the expectation of being bailed out if needed later.

“It is really an indiscriminate procedure that would violate the terms of the contract that provide for loan-by-loan decision making,” George Miller, executive director of the American Securitization Forum, said in an interview this month. A broad approach would “significantly disrupt the reasonable expectation of investors” in the $7.1 trillion market for bonds backed by mortgages.

Back to the Paulson initiative. As noted initially, the Bloomberg report makes clear that the plan, if it even can be called that, is at a preliminary stage:

Paulson was joined yesterday by Federal Deposit Insurance Corp. Chairman Sheila Bair, Comptroller of the Currency John Dugan and Office of Thrift Supervision Director John Reich. Also represented was the American Securitization Forum, which lobbies for investors, traders, underwriters, accounting firms, ratings companies and other institutions involved in the creation and sale of mortgage-backed securities.

Bair has proposed letting borrowers with adjustable-rate subprime mortgages, who are living in their homes and unable to afford resets, get extensions on the starter rate for at least five years. They could also be offered 30-year fixed-rate loans. Reich prefers a three-year freeze…

Jennifer Zuccarelli, a Treasury spokeswoman in Washington, declined to discuss the meeting in detail. “We are encouraged progress is being made,” she said…

Regulators still lack reliable estimates on the extent of the subprime mortgage crisis.

Three months after they asked banks to modify loans for borrowers at risk of default, agencies have little comprehensive data on what lenders and loan servicers have done, officials say.

The Treasury has urged the Mortgage Bankers Association to gather precise data on loan modifications.

The Journal’s coverage, by comparison, was breathless:

The Bush administration and major financial institutions are close to agreeing on a plan that would temporarily freeze interest rates on certain troubled subprime home loans, according to people familiar with the negotiations…. People familiar with the talks say the individual members have agreed to follow any agreement reached by the coalition, which is called the Hope Now Alliance….

In general, the government and the coalition have largely agreed to extend the lower introductory rate on home loans for certain borrowers who will have trouble making payments once their mortgages increase…

Exactly which borrowers will qualify for the freeze and how long the freeze would last are yet to be determined. Under one scenario, the freeze could run as long as seven years. The parties are developing standard criteria that would determine eligibility. The criteria should be finalized by the end of year.

Mortgage servicers — the companies that collect loan payments — are a key part of the coalition, because they are the companies that deal directly with borrowers. Often the servicer is different from the company that originally made the loan. Citigroup and Countrywide are among the nation’s biggest mortgage servicers. The mortgage servicers in the coalition represent 84% of the overall subprime market. The coalition also includes lenders, investors and mortgage counselors…

Among the holdouts have been investors, who typically hold securities backed by mortgages. If interest rates are frozen, they would lose the potential benefit of higher payments. But investors have cautiously moved toward cooperation, likely on the grounds that it’s better to get some interest than none at all.

At a meeting at the Treasury Department yesterday, coalition members told Mr. Paulson and other regulators that they are on track to announce the new industry guidelines by year’s end, according to a senior Treasury official. Among those attending were representatives of Wells Fargo, Washington Mutual, Citigroup and the American Securitization Forum, a group whose members issue, buy and rate securities backed by bundles of mortgages.

“There has been a convergence of thought on this,” said William Ruberry, spokesman for the Office of Thrift Supervision, which is also involved in the discussions.

A spokeswoman for the American Securitization Forum, which earlier resisted a broad approach to changing loan terms, said: “We support loan modifications in appropriate circumstances and are working to establish systematic procedures to facilitate their delivery.”

Treasury officials say financial institutions are likely to set criteria that divide subprime borrowers into three groups: those who can continue to make their payments even if rates rise, those who can’t afford their mortgages even if rates stay steady, and those who could keep their homes if the maturity date of their mortgages were extended or the interest rates remained at the teaser rates. Only the third group would be eligible for help.

Note that the American Securitization Forum seems to be playing both sides of the street at the moment, and as a lobbying organization, its actions are not binding on its members. Recall also that hedge fund Paulson & Co. threatened to sue Bear Stearns during the unwinding of its hedge funds. It was never entirely clear what the issues were, but it appeared to involve “class warfare” or actions that had the (perhaps unintended) effect of aiding one tranche in a securitization at the expense of another. In other words, fairly arcane issues can be grist for litigation.

Consider finally that any plan is not legally binding and is merely a set of guidelines for the industry, so interpretation is likely to vary. As with the state rescue plans, it may turn out that too few borrowers meet the criteria set forth for the program to have much impact.

Even if the dreadfully named Hope Now Alliance comes up with a remedy for borrowers, don’t assume it can’t be contested as an illegal breaching of contractual rights.

Update 11/10, 6:15 PM: Paul Kedrowsky provides further detail as to why this idea is problematic. First he cites the Financial Times:

Industry executives, market participants and several analysts said implementing any plan would be complicated and riddled with technical and political problems, including possibly encouraging otherwise stable borrowers to miss payments. “If you are a borrower in the group that gets left behind by this scheme, you have a set of perverse incentives to default in order to get the break. It has moral hazard written all over it,” said Don Brownstein, chief executive of Structured Portfolio Management, a hedge fund.

Several mortgage experts also said categorising borrowers would be difficult, given that their financial information might never have been collected before.

Note that the moral hazard comment is based on a misunderstanding of the proposal. It is for borrowers who have made their payments but likely won’t be able to, at least consistently, once the reset hits. Remember, the program is supposed to help only the Deserving Poor. But other plans have found it is hard to get borrowers who are current on teasers thorough an application process before the reset hits. Most turn to relief post reset, when they are in trouble, and thus they are screened out.

He also quotes an Institutional Investor story that points out that the lenders/servicers aren’t within their rights to modify any securitized subprimes, and unhappy investors who were looking forward to a reset-created uptick in payments may sue.