Should Congress bail out borrowers in trouble?

John W. Schoen • Profile • E-mail

Congress is talking about a variety of measures to help borrowers with adjustable mortgages who are facing higher monthly payments and risk losing their houses. The discussion has many readers wondering: Why should taxpayers bail out these borrowers? If they signed up for an adjustable rate, these readers suggest, shouldn’t they be prepared to deal with the consequences?

An adjustable (mortgage) is adjustable: The buyers got a lower price to take the risk of higher rates down the road. They knew what they were doing and the risks they were taking. Since when does this require a big government bailout?
— Scott, N.Y.

What many people miss in this whole story is that these adjustable loans are not like the ones most homeowners are familiar with.

Before these exotic mortgages came along, an “adjustable” mortgage was a much more stable product. Usually, you got three, five or even seven years of fixed payments, which allowed you to “grow into” the monthly payment and gave you plenty of time to get ready for a reset if it looked like it was coming.

Most defaults happen within the first 18-24 months. Statistically, if you make it three years into an ARM, you’re much less likely to default. So the initial years of fixed payments for traditional ARMs were intended to help people get past that hurdle. When the reset happened, you were still fixed for a year. If it looked like rates were moving significantly higher, you could usually refinance to a fixed rate — with no penalty.

Though these traditional ARMs are still available, the products that have caused much of the problems are different — these are adjustables on steroids. The most problematic is something called the “Option ARM.” The way it works is you’re given a choice — every month — of several payment options you’d like to make. What often was not explained to these borrowers was that the lowest-cost options simply tacked on additional principal to the loan.

That, of course, would increase every subsequent monthly payment option — because you now have a bigger loan. These payments could also reset every month — much faster than what most people think of as an adjustable-rate mortgage. These Option ARMs also carry very heavy prepayment penalties (perhaps $15,000 on a $250,000 mortgage) that make refinancing extremely costly.

Worse, a substantial number of people who holding these mortgages (we’ve seen estimates of 20 to 40 percent) had perfectly good credit, never had a problem managing their debt or finances and got sold one of these things (which they didn’t need) only to get caught in a financial nightmare. Some have now had their credit ruined and can’t refinance.

The “bailout” in question is still a work in progress. But to help avert some foreclosures, you wouldn’t have use taxpayer dollars to cover losses directly — certainly not for the lenders and brokers who created this mess. Nor should is there much sympathy for the speculators who jumped in trying to “flip” a property for quick profits — or who lied about occupying a home to qualify for lower rates.

The aim is to get people who have decent jobs and income and could afford a normal mortgage out of these exotic loans before they lose the house that constitutes their primary residence. By identifying those with relatively good credit, nullifying the prepayment penalty, and letting them back under the risk umbrella of FHA insurance or the Freddie Mac or Fannie Mae conforming loans that they should have been sold in the first place, you could also lower their payments. The interest rates on these exotic loans are sometimes much higher because they don’t conform to approved lending standards.

In the meantime, regulators have to get serious about cracking down on brokers and lenders who are selling this financial garbage to people who don’t have the financial sophistication to see how punishing these loans can be. Many of the folks who went for these things never had a mortgage and were told, “Relax, lots of people have adjustable mortgages.”  Some brokers also promised borrowers they could refinance in a few years after home prices rose or they built up better credit. We’ve talked to longtime, reputable lenders who were horrified at the pitches they were hearing from some of their more aggressive competitors.

Why would you lend someone money if you know they can’t pay it back? The reason is that many lenders and brokers didn’t have to worry about whether the loan would go bad: They sold the loan to investors within a week, collecting very high origination fees, and moved on to the next borrower. The investors who bought these securities thought their computer models protected them from the risk of default, based in large part on assurances from bond rating agencies that gave these mortgage pools top ratings. But somewhere along the line, it turns out these assumptions were wrong.

Now, lenders have pulled back sharply making it harder for everyone to get a loan. Unless some effort is made to head off the wave of future foreclosures, it will take that much longer for the housing market to stabilize.

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