President Bush's plan to freeze interest rates on some subprime mortgages may prove to be a cure that breeds another disease.
"If the government goes in and changes contracts it will definitely have a chilling effect on the securitization of mortgages," said Milton Ezrati, senior economist and market strategist at Lord Abbett & Co. in Jersey City, New Jersey, which oversees $120 billion in assets. "When the government comes in and says you have contracted to have this arrangement and you can no longer have it, I think it opens the door for lawsuits."
Bush and Treasury Secretary Henry Paulson on Thursday announced an agreement with lenders that will fix rates on some loans for five years. The deal will help borrowers who will fall behind once rates reset to higher levels through July 2010. The plan may force investors in the $6.3 trillion market for home- loan bonds, created by pooling loans and funneling interest payments to bondholders, to revalue their holdings.
"It could end up there's less confidence in the viability in the bond markets and the mortgage markets going forward and it could lead to higher interest rates and higher mortgage rates for everybody," said Kenneth Hackel, managing director of fixed-income strategy at RBS Greenwich Capital Markets.
Hackel said in an interview from his Greenwich, Connecticut, office that he has been "fielding a lot of calls" from clients "pounding the tables and beating the drums."
The American Securitization Forum, the New York-based industry group that worked with regulators to forge the deal, said Bush's plan is designed to work within the existing contracts. As part of a typical bond contract, servicers are required to modify loans only when it would yield more cash to debtholders than a foreclosure. Agreements also state that loans can't be modified unless a default is "reasonably foreseeable."
Servicers will be acting in the best interest of bond investors because foreclosures would cause greater losses, the ASF said in a statement Thursday. The ASF cautioned servicers against modifying more loans than allowed under some contracts.
"The initial reaction of a lot of people including myself a week ago would have been, 'Hey this isn't fair,"' said Andrew Harding, chief investment officer for fixed income at Allegiant Asset Management in Cleveland, which manages $18 billion. "It isn't fair but it most likely is in the best interest of both those who are making payments and those who can't make higher payments."
Mortgage securities and leveraged loans have already caused $66 billion of losses at the world's banks. Goldman Sachs Group Inc. estimated last month that losses in credit markets worldwide may reach $726 billion.
Foreclosures almost doubled in October from a year earlier as borrowers with poor credit failed to make higher payments, Irvine, Calif.-based RealtyTrac Inc. said Nov. 29. Credit Suisse Group analysts project 775,000 homes with $143 billion of mortgage debt will go into foreclosure in the next two years.
The agreement addresses homeowners unable to afford higher interest rates once starter rates increase. The options are freezing rates or refinancing into either a new private mortgage or a Federal Housing Administration-backed loan. The measures may help more than a million subprime borrowers avoid foreclosure over the next two years, Bush said.
"If investors all of a sudden feel that a contract can be changed at the whim of industry participants or at the jawboning of government, ultimately that could have the effect of cutting off capital," said Joshua Rosner, managing director at New York-based research firm Graham Fisher & Co.
Standard & Poor's said Thursday that freezing rates on subprime mortgage loans may lead to credit-rating reductions on some mortgage bonds. The government's plan may shrink the difference between interest payments received from home loans and the interest due to bondholders, S&P said in a report.