November 30, 2007 / Lex / Macroeconomics & markets - Saving subprime homeowners / Lex / Macroeconomics & markets - Saving subprime homeowners

As efforts gather to save those who consumed and speculated, I begin to hopelessly think that the US financial system will never be whole again. The fed talks about cutting rates, the government talks to the banks about freezing interest payments to sub prime borrowers, banks talk to the US Treasury about a super fund to save the credit market. All patch solutions that are good in theory but will fall short in practise and the financial system will be even in a worse situation down the road.

The pain of today's environment is necessary to reprice and vet the system for its excess's. without this repricing of risk and excess, all solution will come back to haunt us.

The article below from the financial times sum it all.

As a general rule, the more grandiose the title, the less achievable the objective. The White House wants its “Hope Now Alliance” initiative ready by the end of the year. This aims to alleviate the worst effects of an estimated $500bn of subprime mortgage rate resets in 2008.

Hope Now will apparently focus on delaying rate increases for some loans. In theory, this will reduce defaults, alleviating pressure on the housing market and wider economy. But how to make it work? Right now, the talk is of helping only those borrowers who fall in the middle ground of being able to afford a house at current rates but not so viable they can do without help. Who decides, and how? If the plan is too narrow, it will not be effective enough. Too wide and it becomes an indiscriminate bail-out.

There is a logistical issue, too. Assessing a borrower’s eligibility for modifying terms involves some effort. The joke is that this time, lenders might have to go to more trouble and expense than they did when many subprime loans were originated. That means hiring more people, not cutting headcount as many mortgage servicers are doing.

That reduces the potential gains to be made by modifying loans rather than foreclosing against them. On top of this, what little data there is – modifications have hitherto tended to be small-scale – suggests 35 per cent or more of such loans default within two years anyway. It is also unclear what effect this would have on mortgage-backed securities. Lower default rates upfront might help, but lower payments and longer schedules on underlying loans could affect ratings and cash flows.

Beyond this, moral hazard raises its ugly head. Using the wonders of securitised finance to bring people into the ranks of homeowners who could not really afford it created the subprime mess. Keeping them there by putting off the day of reckoning does not sound like the best way of restoring long-term stability

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