Paulson goes to Washington, loses his way

ANALYST'S VIEW

If you're like me, you've spent the last few days sorting through the sketchy outline of the US Treasury's sub-prime rescue plan and mulling the potential impact. (Hey, I never said I was a swinger!)

We learned last week that Treasury Secretary Hank Paulson was working with the mortgage industry and major financial institutions to craft a plan to freeze introductory teaser rates on certain sub-prime mortgages that are due to reset higher, as specified by the original terms of the loan. Such a plan is easier said that done.

In the old days, a mortgage lender - in many cases, your local banker - had a relationship with the borrower. When a homeowner fell upon hard times, he and his banker would sit down to renegotiate the loan. It was in the interest of both the homeowner (he keeps the house) and the banker (he avoids costly foreclosure) to modify the loan terms.

Nowadays, sub-prime loans are bundled, sold, chopped up into pieces and packaged into collateralized debt obligations. The lender - in this case, the owner of a CDO tranche - has been replaced by a Cayman Islands hedge fund, a Florida municipality or a German bank. Their interests aren't necessarily aligned with those of the homeowner, not to mention one another.

Take a number
According to the broad outlines of the plan, the Treasury will divide sub-prime borrowers into four groups. Group 1 includes those who can afford the higher mortgage reset rate. "These homeowners need no assistance," Paulson explained at a housing conference in Washington yesterday. Check.

Group 2 consists of the folks who haven't been able to pay the teaser rate, not to mention the higher reset rate. Implicit in Group 2's specifications is the fact that these people couldn't afford their mortgage in the first place, lied or were encouraged to lie about their income, got a no-doc, no- questions-asked loan or were victims of fraud. They were counting on higher home prices and refinancing as a way out. Some of these homeowners will become renters again," Paulson said. Check.

Group 3 consists of the homeowners who might "choose to refinance their mortgage", Paulson said.

Misplaced incentives
Group 4 includes those who can continue to make their mortgage payments if the teaser rate stays in effect or the maturity of the loan is extended. For this category, and this category alone, help is on the way. If fraud was widespread during the housing bubble, the current plan has its own set of incentives.

"People will come up with eight ways of rearranging their finances to stay in Group 4," said Ram Bhagavatula, managing director at Combinatorics Capital LLC, a New York hedge fund.

What the Treasury is trying to do is "streamline the process for loan modification and identify good candidates" since the sheer volume of sub-prime delinquencies makes a case- by-case analysis impossible, said Andy Laperriere, a managing director at the ISI Group in Washington. "It's a perfectly sensible idea, as long as it doesn't throw investors under the bus."

So what's the good news here? "It's a big misconception to think that (mortgage) resets are responsible for the delinquencies," Laperriere said.

Of the sub-prime loans made in 2006 and scheduled to reset in 2008, some 25 per cent are already delinquent, he said. "What's driving the delinquencies is that people can't afford the initial payments," Laperriere said. That's a problem Paulson's plan won't fix.

(The author is a Bloomberg News columnist)