US Subprime Rate Freeze - Commentary

By: Daryl Ching, Clarity Financial Strategy

Date: December 7, 2007

On December 6, George Bush unveiled a plan to freeze interest rates on subprime mortgages for five years. Leading up to 2007, with a booming real estate market, US lenders have been aggressively offering mortgages with low teaser rates, that balloon to a regular variable rate after a certain period of time, usually two years. The intention was to attract borrowers with poor credit quality and offer them rates that they could afford initially. As rates have been resetting to normal levels, there has been an increase in defaults, as borrowers can no longer afford to make the higher mortgage payments.

US Treasury Secretary Henry Paulson told reporters that this plan will avoid foreclosures and give the nation a chance to work its way through the housing cycle. The US subprime mortgage market is estimated to be US$1.3 trillion. Reports have indicated defaults (90 days delinquencies) / foreclosures to be anywhere between 16-20% to date. There is estimated to be an additional $500 billion of mortgages resetting in 2008.

I agree that this plan will temporarily slow down the rate of defaults and give the market some breathing space. Investors of Canadian ABCP with subprime exposure can stand to benefit from this plan, especially if the term to maturity of the assets is within a five year timeframe. However, we have to take a look at Bush's plan from several angles.

In order for this plan to work, the US government will need to receive some form of consensus from the investors who currently hold the subprime risk. Investors who had agreed to these investments had likely expected a greater pickup in return on their investments, which can only be received from higher mortgage rates. Also, in securitization transactions, a common form of credit enhancement to protect against losses is excess spread - yield on mortgages minus funding costs. For the borrowers who can afford to pay the higher reset mortgage rates, their proceeds will be used as a cushion for losses and will also help pay the higher returns to investors who have agreed to take on this risk.

Investors will have to decide if the resulting decrease in defaults more than offsets the yield they could have earned from borrowers who continue to make mortgage payments. A couple more important questions should be asked when thinking about the long term:

1) Are we not just delaying the inevitable? Paulson argues that by pushing the resets out five years, we may push them out to a higher point in the credit cycle. However, is it not the poor underwriting of mortgages that has led to this crisis and drop in housing prices in the first place? I can only believe that the delay will lead to the same problem in five years.

2) There is always the debate about whether government intervention, particularly bail outs are good for the capital markets. Have the various participants in the financial markets learned their lesson? Will we see this happen again within the next century? Do government bail outs encourage the market to continue its wreckless underwriting and help participants forget about the mess that has been created?

While I am convinced that this plan provides a bandaid solution that will limit defaults in the subprime sector into 2008, I am not convinced that mortgage rate freeze is good for the market in the long term. Sometimes, people only learn lessons the hard way, and that is to feel the pain of a loss from poor investment decisions.

Daryl Ching
Clarity Financial Strategy