Big Time ARM Wrestling | Citizens Against Government Waste

Big Time ARM Wrestling

The WasteWatcher

The country continues to experience uncertainty and volatility in the financial markets as a result of the crisis in the mortgage industry.  Financial services companies have been hit hard.  For example, Merrill Lynch announced an $8.4 billion writedown in October, and Citigroup received a $7.5 billion infusion of cash from investors in Abu Dhabi, United Arab Emirates.

For its part, Congress has been trying to help homeowners who face foreclosure or need help refinancing homes they can no longer afford.  Developments in the mortgage market are fluid and the industry began taking corrective action to mitigate problems for some subprime borrowers.  One housing advocate told The Wall Street Journal that some loan-service providers are “already freezing rates for five to seven years.” 

After initial resistance, Treasury Secretary Henry Paulson announced on December 5 that the Bush Administration will support a proposal crafted by a coalition of mortgage industry players, consumer groups, and bank regulators to freeze interest rates on certain types of adjustable loans in order to prevent or forestall foreclosures.  San Francisco Chronicle columnist Kathleen Pender called it a “methadone plan for the mortgage industry.”  It asks lenders to freeze interest rates for five years for a certain segment of subprime borrowers who made “bad, greedy or uninformed decisions” (Pender’s words).  

One earlier proposition, initially pushed by Sen. Charles Schumer (D-N.Y.) and House Financial Services Committee Chairman Barney Frank (D-Mass.) was to use the housing government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac to play “deus ex machina” to the mortgage market. Schumer favored lifting the caps on the amount of mortgage-backed securities (MBS) that the GSEs could hold in portfolio, giving them temporary authority to buy mortgages valued at more than $417,000, or reconfiguring their minimum capital requirements, in order to pump liquidity into the market.    

Thankfully, enthusiasm for allowing Fannie and

Freddie to take on more risk has waned.  And for good reasons.  First, Fannie and Freddie reported combined losses of $3 billion in the third quarter.  Then, a November 15 article by Peter Eaves in Fortune magazine further roiled confidence in the GSEs’ accounting practices when he described an obscure change in how Fannie Mae was calculating its credit-loss ratios. Financial analysts were suspicious of the timing of the change and worry that Fannie might be trying to camouflage deeper losses.  In fact, Fannie announced on December 4 that its losses will worsen in 2008, its dividend will be cut by 30 percent, and it will sell $7 billion in stock to raise cash.   

Though much of the talk of liberalizing the rules governing the GSEs has cooled, the companies can and should stick with their traditional securitization role in the secondary mortgage market.  The GSEs’ top regulator, the Office of Federal Housing Enterprise Oversight Director James Lockhart, said as much in a CNBC interview on October 22.  “They have already significant flexibility,” Lockhart said. “Between Freddie and Fannie, they are securitizing over $100 billion a month. They are also seeing about $30 billion a month in the run-off of their portfolios, and we actually gave them flexibility about a month ago that amounts to almost another $10 billion a month.  So they have more than enough flexibility within their current structure to provide liquidity to the subprime market in particular.” 

There is no reason for Fannie or Freddie to enter the jumbo market, since their mission is to provide liquidity for conventional conforming loans and the jumbo market is already served by the private sector.  In the long run, Congress should address the GSEs’ problems by passing a comprehensive GSE reform bill. 

With or without Fannie and Freddie’s involvement, there are questions about the advisability of a federal bailout of the mortgage market.  The government is a blunt and inaccurate instrument.  While it always sounds attractive to have the feds swoop in and “fix” everything, the details of such plans always generate adverse, unintended consequences. 

For example, who would be eligible for the taxpayer-backed handouts?  According to a December 4 Wall Street Journal online commentary by Andy Laperriere, a managing director at the ISI Group in Washington, D.C., “a majority of subprime loans during the past few years have been cash-out refinance loans.”  In the commentary, Laperriere poses a series of probing questions to illustrate the complexities of a taxpayer-subsidized bailout.  For instance, is it fair to force taxpayers to subsidize those who took no-documentation loans or lied on their applications?  What about borrowers who face steeply escalating payments from an adjustable rate mortgage, but who still have other assets, like cars, second homes, or stock portfolios?  Do they deserve taxpayer money?  Wouldn’t a bailout also indirectly help the irresponsible lenders who created the mess?  And, most importantly, what kind of message does a bailout send to those who wisely resisted the urge to sign on the dotted line for a mortgage they clearly could not afford? 

As one Michigan small business owner quipped in a December 4th Wall Street Journal report, “People have to be responsible for their own actions.  What are you going to do when their credit cards get due and they can’t pay?  Are you going to bail them out on that, too?”  Excellent question.  The answer should be “no.” 

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