The latest in the world of mortgage finance is a pending agreement with large banks and the feds on how to avoid foreclosures. The biggest buzzword out there regarding subprime loans is reset. And the supposed agreement will postpone the first adjustment of eligible loans. Will it help? And who will it hurt? And who might be absolved from mistakes in judgment? These are all valid questions. And it might appear that the third one is not getting asked very often.
Many of the subprime loans are 2/28s or 3/27s. They are not really 2/1 Adjustable Rate Mortgages because once the adjustments start, they occur every 6 months rather than every year. And they are based on a LIBOR index which tends to run higher than the US Treasury index. The real issue here, however, is the margin. And the margin is what determines the rate. By adding the margin to the index you arrive at the new rate. And for many of these loans, the initial rate was artificially low. By that, I mean the addition of the margin and index yielded a higher rate than the actual start rate. So, if the index remained the same over the next 2 years, there would be a guaranteed rate increase because of the margin. And there lies the problem. Let's say the LIBOR was at 5% when one of these loans was granted and the borrower received a note rate of 8%. A typical margin on this type of loan is 6% although many have higher margins than that. If the maximum increase is 3% initially, the LIBOR would have to go down 3% just for the rate to remain the same. If it remained the same, then by adding the margin of 6%, the borrower would have a new rate of 11%.
Many borrowers who went into this type of loan had credit issues, but many could have used another fixed rate program at more attractive rates. There were problems with the lenders who had lax underwriting standards, but they have sold the loans and only service them now. Those who bought the loans are now faced with the prospect of receiving a much lower return than anticipated. But it beats having to sell a foreclosed property. Or so the logic goes. In this game of musical chairs, the investor is left standing. And those who bought securities backed by these loans are in an even less favorable position. They never even were in the game and were never near a chair.
Some of the large lenders have seen their stock climb on the release of this news today. I am not so sure they should have been rewarded in this fashion. Time will tell if this will come to fruition, but for many, it is only postponing the inevitable. So, how will it help?
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