Bush Administration Unveils Campaign to Stabilize the Housing, Mortgage, and Securities Markets

• Further increases in delinquency and foreclosure rates in the third quarter of 2007, with the overall foreclosure rate moving to a record high.
• Further erosion in the credit ratings and valuations of mortgage-backed securities.
• Downward pressure on house prices.
• A generalized tightening in credit conditions in mortgage markets to unprecedented levels and a widening of borrowing spreads, even for prime-rated borrowers.
• Significant write-offs in the commercial banking and mortgage lending industry that threaten to weaken capital adequacy ratios in the banking system and lead to a more generalized credit crunch, which would undermine the business cycle expansion.

The major new initiative that the administration announced today is a voluntary agreement among mortgage lenders and servicers to freeze interest-rate resets on a broad swath of adjustable-rate (and mainly subprime) mortgages that had been originally granted between January 2005 and July 31, 2007. Reportedly, the rate freeze will apply to loans made during this period, and will cover loans that had been scheduled to rise to higher rates between January 1, 2008, and July 31, 2010. As many as two million borrowers are facing interest-rate resets over the next two years. Many details of this coordinated plan are yet to be worked out, in particular, the terms and standards under which these loan modifications can take place, including how to deal with potential litigation risk from investors because of their contractual obligations under the servicing agreements; and a host of regulatory and tax issues, including the issues of loss recognition and the potential tax consequences for both borrowers and lenders. Ultimately, the tax code and/or write-off provisions (including more generous loss carry-forwards) may need to be tweaked to create strong incentives for mortgage lenders to participate.

While the details of the plan are scarce, the intent and purpose are sound. Both investors and servicers in the mortgage industry generally want to work with borrowers to avoid foreclosure. Borrowers who have been current in their payments but could default after reset, for instance, may be able to work with their lender or servicer to adjust their payments or otherwise change their loans to make them more manageable. Loan modifications that avoid foreclosure not only help homeowners, they are usually cost-effective for investors. The critical ingredient here is that that the costs to the investors and servicers of the loan modifications in many cases would be less than the cost of foreclosure.

Moreover, there is clearly a collective interest among investors and servicers to stabilize the mortgage and housing markets. Steady increases in the foreclosure rate will simply add more supply to a market that is struggling to reduce supply in line with lower demand, and thereby reduce bloated inventories. This process has led to further downward pressure on prices, which then feeds back to put more upward pressure on foreclosures. In other words, there is a clear collective interest in arresting a vicious downward spiral that has been gaining momentum in recent months. While the collective interest is huge, there is also a classic "free-rider" problem, so the program will need to create some incentives to prevent the "free rider" problem from unraveling the potential positive impact of the program.

Secretary Paulson also announced that the administration was proposing a temporary expansion of authority for states and localities to issue tax-exempt mortgage revenue bonds geared to helping people refinance out of subprime mortgages.

Beyond the proposed "interest rate freeze" initiative, the administration is ramping up pressure on Congress to move forward on several key legislative initiatives that have stalled in recent months. That would include a bill to expand the capacity of the Federal Housing Authority to be more active in the subprime mortgage markets, as well as potential changes to current restrictions on the ability of the GSEs (Fannie Mae and Freddie Mac) to respond to the crisis. In addition, a key tax proposal that would immunize borrowers from the tax impact of potential mortgage-payment forgiveness is stalled in the complicated Rangel tax bill. Congress also has not made any progress on a recent proposal by the chairman of the Federal Reserve Board to provide more liquidity to the mortgage insurance market and expand the capabilities of the GSEs to securitize mortgages beyond the conforming limit of $417,000, which effectively discriminates against states that have relatively high-cost housing markets.

In the absence of substantive progress by the Congress in these areas, the Bush administration is moving forward in areas within its sphere of influence that could have a positive impact on the housing and mortgage markets and avoid the perpetuation of a vicious downward cycle. The proposed "interest rate freeze" program—if it is structured with the right incentives, standards, and regulatory features to deal with the potential pitfalls—is certainly a step in the right direction. The program will also have a higher probability of success in an environment of lower interest rates, which would substantially mitigate mortgage refunding costs and buffer the inevitable further hits to the capital adequacy positions of major financial institutions from mortgage valuation write-offs. Thus, the expected reductions in interest rates by the Federal Reserve over the next couple of months should create the kind of conditions in the financial markets that would support the success of this new program.

Ultimately, the program would be successful if there was a high rate of participation among the mortgage industry, leading to a stabilization of foreclosure rates in the first half of next year, followed by a reduction of foreclosure rates in an unusually timely fashion during the second half of 2008.