Jack M. Guttentag The Mortgage Professor

How bad is the current financial crisis? It will probably enter the record books as the second-worst in the last hundred years. The worst was in the early 1930s, when thousands of banks failed and the mortgage market shut down entirely.

It hasn't shut down this time, thanks in large part to federal institutions created during the '30s to deal with that crisis.

Lost Confidence

To appreciate why it could have been a lot worse, consider that the housing finance system is really two overlapping systems that exist side by side. One system consists of portfolio lenders, mostly depository institutions, which hold the mortgage loans they originate. The portfolio system was the larger part of housing finance prior to the savings and loan crisis of the '80s, but gradually lost ground thereafter.

The other system consists of temporary lenders who sell loans in the secondary market to firms that securitize them, or resell to still other firms that securitize them. Securitization means placing mortgages in a pool and issuing mortgage-backed securities (MBS) against the pool. This secondary market system began in the early '70s and grew at the expense of the portfolio system -- until the recent crisis.

The crisis originated in the subprime segment of the secondary market system, and quickly spread. The crux of the crisis is a loss of confidence by the investors who purchase MBS and their retreat to the sidelines. When investors stop buying, the secondary market system grinds to a halt.

It Could Be Worse

One part of the secondary market system, however, has continued to function more or less normally. This is the "conforming loan" market, which covers loans no larger than $417,000 that meet the eligibility requirements of Fannie Mae and Freddie Mac. Investors have retained their confidence in these two agencies, which they assume would be supported by the federal government if that became necessary. Hence, they continue to purchase the MBS issued and insured by the agencies.

The crisis has also reenergized the portfolio system, which has expanded into many of the market niches left vacant by temporary lenders who no longer have buyers. Portfolio lenders have been turning more often to mortgage insurance, both from the Federal Housing Administration (FHA) and from private mortgage insurers. The FHA shrank markedly from 2000 to 2006 as the subprime market expanded, while private mortgage insurance was negatively affected by lender self-insurance in the form of second mortgage "piggybacks." Both trends have been reversed.

Portfolio lenders have raised additional funds from channels unaffected by the crisis: by selling certificates of deposit, which are insured by the FDIC, and by borrowing record-breaking amounts from the Federal Home Loan Banks. The banks raise money by selling bonds, and like Fannie and Freddie, they continue to enjoy the confidence of investors.

Four of the five federal agencies now supporting the market were created during the financial crisis of the '30s. The only exception is Freddie Mac, which was formed in 1970. If not for these institutions, the current crisis would be much worse.

A Premium on Fright

But it's bad enough. Portfolio lenders have replaced only part of the shortfall left by temporary lenders deserted by investors. The portfolio lenders live in the same world as secondary market investors, see the same frightening data on foreclosures, and have tightened their underwriting requirements across the board.

Further, many are constrained by capital requirements, especially those who participated in the secondary market system as investors and have suffered capital losses.

The upshot is that, just as many loans were made during 2005 and 2006 that shouldn't have been made, today there are loans that should be made that aren't. Further, the prices of all deviations from underwriting perfection contain a "fright premium," and are therefore priced higher than they ought to be. This is true even in the conforming market, where Fannie and Freddie have raised the price increments on borrowers with less than excellent credit.

More Surprises to Come

This semi-paralyzed market will continue until investor confidence is restored. Key players are the investment banks and hedge funds who sold MBS when prices were high in expectation that they could buy them back later at lower prices. They have large short positions, and at some point they must go into the market to buy the MBS that they owe. They'll do that when they decide that MBS prices have reached a bottom.

That won't happen before we see the end of unpleasant surprises -- large value write-downs by major U.S. firms, or revelations by some previously unknown foreign institution that they too bought subprime-contaminated securities and are taking a major hit. Since most firms everywhere come clean at year-end, hopefully the surprises will stop then.

Once the surprises stop, the shorts will look for a bottom in house prices and a peak in foreclosures. When both become clear, even if not imminent, they'll make their move.

Foreclosures Yet to Peak

Neither is in sight yet. Housing markets are always slow to adjust, partly because sellers practice denial and are stubborn about reducing prices, while many buyers defer purchases because they expect prices to decline. Rising foreclosure rates strengthen this attitude by buyers, since buyers understand that foreclosure sales depress prices.

The peak in foreclosures is not yet evident because of the large overhang of interest rate resets on adjustable rate mortgages (ARMs). Since many borrowers facing rate resets will find the new payment unaffordable and won't have the equity or credit needed to refinance, the outlook is for continued increases in foreclosures.

The hope, however, is that the relief plan orchestrated by Treasury secretary Henry Paulson will change this expectation.

The Relief Plan

The federal government initiated and to some degree orchestrated the relief plan, the details of which were released on Dec. 6. No government funding is involved in it, however -- it's a private initiative developed by the American Securitization Forum, a professional organization of firms involved in the securitization process. The plan applies to one category of firms belonging to the organization: servicers of securitized ARMs.

The major goal is to reduce foreclosures of securitized ARMs facing rate resets by extending the initial rates for five years. The eligibility rules are designed to make implementation possible on a wholesale fast-track basis, as opposed to the slow case-by-case basis that's the rule, which involves the collection and evaluation of new data concerning the borrower. It's also intended to be consistent with the contractual obligation of servicers to modify loan contracts only when it's in the interest of the investor.

Who Gets What

Borrowers eligible for the fast track:

• Took out ARMs with initial rate periods of two or three years between Jan. 1, 2005, and July 31, 2007.

• Face rate resets between Jan. 1, 2008, and July 31, 2010, that will increase their payment by more than 10 percent.

• Occupy the property as their principal residence, and have been current on their payments for 12 months prior to the rate reset.

• Will be unable to meet the payment increase, as indicated by a FICO score of less than 660, and not more than 10 percent higher than it was at origination.

• Will be unable to refinance, either because their original loan was more than 97 percent of property value, or because they don't qualify for FHA financing.

Not eligible are borrowers who have already had their rates reset and are now struggling; borrowers with high-rate fixed-rate mortgages who are struggling; borrowers who made down payments larger than 3 percent who are struggling; and borrowers with good FICO scores, or who have substantially improved their scores, but are nonetheless struggling.

The inequities in this are obvious but should be kept in perspective. Those not eligible will be no worse off than they are now, and perhaps a little better off. Treating a significant category of borrowers on a wholesale basis will free up more time and resources for treating other borrowers on a case-by-case basis.

Relief Plan, Part Two

The major shortcoming isn't the unequal treatment of groups of equal merit, but the fact that the eligible group is too small to have a decisive effect on market expectations. I view it as a good first step -- about the most that can be expected from the private sector. It remains for the government to take the next step, which should be aimed at tripling or more the number of borrowers offered relief.

The government should mandate that, with the exception noted below, all ARMs originated after Jan. 1, 2005, with rate margins over 4 percent should have their margins reduced to zero. The margin is the spread added to the interest rate index in calculating the new rate after the initial rate period ends. The rule should apply whether the loan has reached its first rate reset or not.

The exception would be any mortgage for which the lender can document that the borrower was informed of the margin at least three days prior to closing.

Crisis Forestalled or Lengthened?

Having the government set aside existing private contracts is not a matter to be taken lightly, but in this case it's well justified. The margin on an ARM is a critically important number to the borrower, but since it doesn't kick in until the first rate adjustment, most borrowers don't ask about it.

Margins above 4 percent are found only on subprime loans, and these borrowers are the least likely to ask. The fact that the government is too inept to make the margin a required disclosure should not absolve lenders of the responsibility for disclosing it.

Another possible intrusion by the government into private contracts, which has been proposed by some politicians, is to declare a moratorium on foreclosures. This is a really bad idea. The objective of the relief plan and my proposed extension of it is to reduce foreclosures, which would shorten the crisis period. A moratorium only pushes foreclosures into the future, which would lengthen the crisis period.