Editorial - Mortgage Meltdown

October 24, 2007
Wall Street Journal

Home foreclosures are picking up speed, and right behind them are the politicians promising to save the guilty and punish the innocent. OK, we exaggerate, but only a little. So this would seem to be the moment to sort the good housing ideas from the bad, with the latter describing most of what is now coming from Washington.

The main problem, financial and increasingly political, is that millions of subprime mortgage loans will have their rates "reset" in the coming months. Their borrowers are able to meet their monthly payments today at the so-called "starter" loan rate, but they might fall behind once those rates reset at a higher rate. The dilemma for the big mortgage lenders is whether to restructure those loans on better terms, foreclose on them, or beg politicians to bail them out.

On this score, the most sensible proposal we've heard is from Sheila Bair of the Federal Deposit Insurance Corp., the federal bank regulator. Ms. Bair is proposing that the mortgage companies (Wamu, J.P. Morgan Chase, et al.) voluntarily rewrite these mortgage contracts. Specifically, she suggests converting subprime loans that are still performing into fixed-rate loans at the lower variable rate.

Yes, the banks would have to accept a lower income stream, but that's better than taking the writeoff from a foreclosure. As many as a million borrowers nationwide might benefit from such treatment, and for hundreds of thousands it could mean keeping their home. We understand the delicacy of asking banks to rewrite their contracts, which is why Ms. Bair says this should be voluntary. But if there's a case of enlightened business self-interest, this is probably it.

A few companies are already responding. Troubled Countrywide Financial announced this week that it will modify the terms of $16 billion in adjustable-rate mortgages through the end of next year. Countrywide has already allowed more than 30,000 customers to restructure their mortgages and will contact an additional 52,000 to offer refinancing options.

This certainly beats the Beltway alternatives, which are either punitive, or put taxpayers on the hook, or both. Among the bailout ideas is a plan that would ask lenders to take a small, 10%-15%, haircut on these subprime loans but then bring in the Federal Housing Administration to insure the rest. This idea has backers on Capitol Hill, and we're told it even has takers at Hank Paulson's Treasury.

But if Mr. Paulson embraces it, he'll be putting taxpayers at risk if housing values decline further. He'll also be sending a terrible signal to lenders, borrowers and investors -- to wit, that Congress will save them from bad decisions. Treasury has spent years warning about the risk to taxpayers from expanding Freddie Mac and Fannie Mae. If it now embraces a larger role for their federal housing cousin, the FHA, Treasury's credibility on Fan and Fred will be zero.

Meanwhile, the House Judiciary Committee will mark up a plan today to allow bankruptcy filers to treat home loans as similar to unsecured credit-card debt, making it easier for people to remain in their homes while reducing what they owe. This sounds great, except that credit-card debt carries a higher rate than debt on your home for a reason. Guess how eager lenders will be to offer low mortgage rates if they have no better chance of collecting on a mortgage than they do on a credit card?

And not to be outdone, House Financial Services Chairman Barney Frank wants to create new registration requirements on mortgage brokers, and new liability for firms that securitize the riskiest mortgages. This is a sure-fire way to make mortgage lending more expensive, especially for people who lack perfect credit or high incomes. But the trial lawyers are overjoyed.

Mr. Frank's bailout also gives delinquent mortgage borrowers a new trick to essentially enjoy free rent for up to 30 years. If a borrower has to endure the sad experience of foreclosure, Mr. Frank wants him to enjoy the ability to recover all of the principal and interest paid over the entire history of the loan -- as long as he can convince a court that he didn't have a reasonable ability to pay at the time the loan was originated. It doesn't take too much imagination to see how this could be abused.

All of these plans reflect the political imperative, or should we say panic, to rescue individuals from bad mortgage decisions. But you can't bail out borrowers without also bailing out lenders and investors -- and down that route lies endless taxpayer liability. Before embracing a radical restructuring of the relationships between American homeowners and mortgage companies, it's worth reviewing the facts: Roughly 35% of homeowners have no mortgage debt remaining on their homes. Of those homeowners still paying a mortgage, 95% are paying on time. And even in the risky category of subprime adjustable-rate loans, more than 83% are still paying on time.

President Bush should advise his Treasury to heed Ms. Bair's counsel and encourage more companies to seek solutions with their customers, not from Uncle Fed.