The Tease of the "Teaser Freeze"

By Kurt Eggert

Professor of Law, Chapman University School of Law

On December 6, the Bush Administration announced a "market-based" solution to the mounting tide of foreclosures that threatens to swamp the economy. But its plan may do more harm than good if it squeezes out real solutions to the foreclosure problem. In a nutshell, the Bush plan is to let the Wall Street insiders who caused the problem do whatever helps themselves the most.

The plan is to provide a "rate freeze" to a select group of subprime borrowers: those who received adjustable subprime loans from 2005 to mid-2007, whose rates will reset between January 1, 2008 and mid-2010, who are able to stay generally current on their loans until the reset but likely will not be able to make the higher reset payments, and who seem unlikely to be able to refinance. Because it helps so few borrowers, the "teaser freeze" may just be a tease. Although two million residential foreclosures have been predicted for the next two years, the Center for Responsible Lending estimates that the Bush plan will help only about 145,000 families, or about 7% of subprime borrowers, which would make the plan the proverbial drop in the bucket.

Worse, by focusing loan modification efforts on this select group, the Bush plan could hurt other borrowers. Getting servicers to modify loans for distressed borrowers has been harder than pulling teeth. Borrowers who fall outside the Bush plan may find loan servicers even less willing or able to spend the time to modify their loans and help them save their houses.

Even for those who fall within the plan, there is not much there there. The plan is completely voluntary and is, by its own terms, "non-exclusive," meaning that servicers do not have to follow the plan. Even the vaunted five-year rate freeze is discretionary, as the rate freeze will only be "generally for five years" but could be much shorter. There are no mandates to do anything and no monitoring to see if anything has been done and, perish the thought, no additional governmental regulation to clean up the mess.

The primary effect of the plan will be to reduce some loan servicer costs associated with loan modifications by allowing servicers to presume that they should modify the loans of the select group of borrowers, without plowing through all of the debtor's income and expense information. While reducing these servicer costs should help some borrowers get loan modifications, the primary benefit will be to the investors and servicers who can therefore keep more of the borrowers' payments.

The plan does not solve many of the most pressing problems. It does nothing to help the multitude of homeowners facing foreclosures right now because their loans have already reset or they already are unable to pay those loans. According to the Mortgage Bankers Association, the rate of new foreclosures and the percentage of loans in the process of foreclosure right now are both at their highest rate ever recorded, in a survey dating back to 1972.

The irony is that Bush's plan was crafted by Wall Street, by the very parties who by and large caused the problem. The subprime meltdown and the wave of foreclosures is the result of a system that paid most of the players in the game not based on the quality of the loans they handled, but on the quantity. The lenders, investment houses, and rating agencies who created, packaged, and sold these loans on Wall Street were paid more if they made more loans. To pump up the number of loans, underwriting standards were thrown out the window and increasingly risky loans, with teaser rates and option payments, were made, often without determining whether borrowers could afford them when the higher rates kicked in. As a result, foreclosures are skyrocketing.

The subprime industry could keep making these hazardous loans because it was virtually unregulated by any governmental agency. Lenders got their orders from Wall Street, from the very parties that now claim to have a plan to solve the problem that they in large part caused.

The great danger is that this plan will squeeze out better and more complete attempts to solve these problems. A broader loan modification system could be crafted, including one that mandates reasonable efforts by servicers. Bankruptcy reform could allow distressedborrowers to modify their loans in bankruptcy and so save their homes, whether they are part of the select group or not. And real reform of the lending process is crucial to keep new risky loans from being made.

The problem of rising foreclosures requires real, substantive solutions, not just handing off the ball to the players who caused the problem in the first place.

Kurt Eggert is a Professor of Law with Chapman University School of Law and has testified to Congress on subprime and securitization issues. He just completed a three year term as a member of the Federal Reserve Board's Consumer Advisory Council.