Paulson Makes A Move

Having criticized U.S. Treasury Secretary Henry Paulson for not taking a leadership role with the subprime crisis, it's good to see that he is adopting an idea put forward by the head of the FDIC and adopted by Governor Arnold Schwartzenegger in California: A rate freeze on the adjustable rate subprime mortgages that will reset at a higher rate in 2008. Estimates are that there are more than $350 billion in such mortgages nationwide that will reset in 2008.

From the news reports he is negotiating a temporary reprieve (and it's unclear how long the freeze will last; my guess is up to five years, a long enough period of time for the real estate market to revive.) I'd prefer a permanent freeze. Nevertheless, for those that are able to make payments on their adjustable rate subprime mortgages at current rates (typically between 7% and 9%) but won't be able to stay current on their payments when their mortgage adjusts to 11% to 13%--or higher--this is good news. It's also a boon to the economy.

To be sure, the plan will bail out some speculators and wealthy homeowners that gambled with a subprime loan. But that's always the case with a comprehensive solution. But these folks are also in the minority. And all the evidence we have in recent months is that the case-by-case loan modification attempts between lending institutions and homeowners wasn't working out. As Federal Reserve Board vice-chairman Donald Kohn said in a recent speech, there's "no need to hold the economy hostage to teach a very small minority of the population a lesson."

With the freeze, homeowners are still obligated to pay their mortgage. By the way, let's be clear: These homeowners aren't paying "cheap" rates. Certainly, that the message of recent Congressional testimony by Michael Krimminger, a special advisor to the head of the FDIC. "The typical structure of these loans is to provide for a starter rate (typically between 7 and 9 percent), followed in 24 or 36 months by a series of steep increases in the interest rate (often totaling 5 percent or more) and a commensurate rise in the monthly payment," said Krimminger. He went on to say that " Almost three quarters of subprime mortgages securitized in 2004 and 2005 were structured in this manner, as were over half the subprime loans made in 2006. Most of these loans also imposed a prepayment penalty if the loan was repaid while the starter rate was still in effect."

This is a disgrace. Lenders should be ashamed of themselves. I don't mind teaching lenders a lesson. It doesn't bother me in the least that the balance sheets of banks and other lenders that wrote these loans take a hit. I just wish it was permanent rather than temporary.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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