For the record, I’m all for giving aid to folks laid off because of the sputtering economy. But, like many others, I’m livid about Obama’s plan to reward irresponsible borrowers with extraordinary government subsidies.
Frankly, I think Obama’s brain trust is so blinded by their politicized sense of social justice and so enamored with the elegance of their mortgage math that they miss the more fundamental implications of their own plan.
Below is an example of how the plan works. The highlights …
Lenders will be encouraged to reduce P&I payments to 38% of the borrowers earnings by adjusting the loans payback period, the interest rate, or the loan balance (i.e. the principal) — or all three.
Think about that for a second. The government is encouraging (forcing ?) lenders to give different borrowers different prices for their product (i.e. mortgages) based on the borrowers ability to pay (ignoring other accumulated debts and using their current level of earnings as a proxy for ability to pay). That’s called “price discrimination” and in most businesses, it is illegal to offer different prices to customers in the “same class of trade”.
Legalities aside, adjusting the payback period, say from 30 to 40 years has minimal impact on P&I payments. At the extreme, the payback period could be stretched forever. That’s called an interest-only loan, and under its terms, a borrower never pays back the loan. Most people think that’s a bad idea.
What about cutting the rate to something in the range of 5%?
If the loan is currently hanging with a predatory rate (say, 10% or more), cutting the interest rate to a fairer market rate probably makes sense.
But, what if a rate cut to prevailing fair market rates isn’t enough? Well, the lender could reduce the interest rate further, say to 3% or 4%.
In other words, the lender could offer an “upside down risk-adjusted rate”. Usually, a more credit worthy borrower is rewarded with a lower interest rate (think “prime”) that reflects the high likelihood that the loan will be repaid. Giving favorable rates to the least credit worthy borrowers (i.e. ones who have already defaulted) defies any reasonable economic or financial logic.
Or, the lender can simply write-off some of the money owed. Most people think that’s a very bad idea. After all, the borrower made a legal and moral commitment to pay the loan back. Why should they be let of the hook ?
Still, let’s pretend that the lender can find a way to get the borrowers payments and earnings in alignment at the magic 38% ratio.
In comes Team Obama. To provide the borrower with a softer financial cushion, the government drives the payment to income ratio down to 31% — splitting the incremental subsidy with the lender.
In other words, the lender reduces the borrower’s annual P&I payments by 3.5% of the borrower’s income and taxpayers kick in 3.5% of the borrower’s income.
Think about that for a second. The lender is pressured to give an even more favorable price to one its least credit worthy customers and we, the taxpayers, reward the borrower with the equivalent of a 3.5% refundable tax credit — earned by simply having bought a house beyond his means and defaulting on his loan obligation. Team Obama sees beauty in that arrangement. Many taxpayers don’t.
But wait, it gets worse. The borrower qualifies for a “good boy” incentive — $1,000 per year for up to 5 years — if he makes timely payments. So, for a defaulting borrower earning $50,000 per year, there’s an extra 2% kicker from the taxpayers — boosting the taxpayers’ subsidy to the equivalent of a 5.5% refundable tax credit.
That, my friends, is a big reward for acting irresponsibly.
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Obama’s Mortgage Foreclosure Plan – An Example
Consider the following case: Skipper earns $35,000 annually and buys a $205,000 home with no money down, signing up for an ARM that starts at a teaser priced 5% with a 30 year payback term. His initial P&I payments are about $1,100 per month. That’s right at the government’s magic ratio of 38% payment to earnings ratio, so Skipper is classified as a responsible buyer.
A year or two later, the ARM gets bumped up to 8% (per the written mortgage contract). Let’s assume that Skipper’s loan balance went down to $200,000 over the period (a liberal assumption that works to his advantage). Skipper’s P&I payments get upped to about $1,500 per month — that’s $17,765 annually, or over 50% of his annual earnings.
Skipper’s in a bind and defaults on his mortgage.
Enter Team Obama.
First, they pressure the lender to reduce Skipper’s rate to get him back into the 38% payment to earnings ratio. Even though Skipper has proven beyond a shadow of a doubt that he’s a credit risk, the lender sucks it up and cuts his rate to a credit worthy borrower’s 5%. That gets his annual P&I payments back down to about $13,000.
Then, to provide Skipper with an economic cushion, Team O moves to cut Skipper’s payment to a more secure 31% of his income — that is, to reduce his P&I payments to about $10,500 per year. (note: itdoesn’t matter whether the reduction comes thru principal reduction or interest rate cut — the economics are the same). And, team O offers to split the $2,500 difference — lender paying half and taxpayers paying half.
Finally, Team O offers Skipper a $1,000 annual bonus (for 5 years) if he doesn’t default again.
Let’s recap the bidding:
First, the lender gives unreliable Skipper a loan at “prime” rates.
Second, the lender subsidizes Skipper with a $1,250 reduction in annual P&I payments
Finally, we taxpayers give Skipper a $2,250 annual subsidy ,,, the equivalent of a 6.4% refundable tax credit … which Skipper earned by buying too expensive of a house and defaulting on his mortgage.
Does that sound like a good idea?
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