There may actually be HOPE NOW

Talk of freezing the interest rates for some subprime borrowers -- somewhat heretical when floated by FDIC chief Sheila Bair in October -- now seems like a good idea even to Wall Street investors in securities backed by subprime mortgages.

The Bush administration has been negotiating with members of its HOPE NOW coalition of lenders and loan servicers to engage in wholesale loan modifications, and an agreement is expected soon (see Inman News story).

Although freezing interest rates on hundreds of thousands of subprime loans would cut the returns investors receive from some mortgage-backed securities, they are now coming around to the idea that they could face more massive losses from defaults in the loan pools that provide their income streams.

Word of the plan has sent the stock of troubled lenders like Countrywide Financial Corp. skyrocketing today. Perhaps even more interesting is what's happening to the stocks of companies that insure mortgages and collateralized debt obligations (CDOs), securities that often include mortgage loans.

The stocks of mortgage insurers like PMI Group, MGIC and Radian Group are all up today, and investors also see brighter prospects for bond insurers like Ambac and MBIA. The stocks of Fannie Mae and Freddie Mac, which own billions and guarantee trillions in mortgage loans, are also roaring back today, even though their exposure to subprime loans is limited.

The bottom line for housing markets? If this move keeps a significant number of borrowers out of foreclosure, that could help slow or stop the free fall in prices in some markets that are flooded with inventory, further reducing foreclosures.

According to Frist American CoreLogic researcher Chris Cagan, every 1 percent decline in home values produces an additional 70,000 foreclosures. That's because as prices fall, more and more homeowners find themselves "upside down," or with no equity in their homes, which encourages them to walk away.

It remains to be seen who will be eligible for interest rate freeze -- perhaps only borrowers who are current on their loans and live in their homes will get a break, and not speculators and second home owners.

But depending on how many foreclosures can be prevented, this is shaping up to be the most significant development yet in the ongoing battle to quell the panic in financial markets that's put the crunch on mortgage lending and magnified the severity of the housing downturn. And instead of a government bailout, it would come at the expense of the same investors who some blame for the loose loan underwriting standards of the boom.

When announced in October, the HOPE NOW initiative was little more than an outreach program to troubled borrowers. Now there is real hope that it will provide relief for borrowers and financial markets alike.

UPDATE: For another take, check out Seth Jayson, writing for The Motley Fool (a site for investors), who calls the idea of freezing ARM rates an idea "so naively populist and antimarket that you would think it came from Hugo Chavez, Evo Morales, or Mahmoud Ahmadinejad."

Jayson says the plan will only make "the credit crunch crunchier."

"If you think credit is tight now, just wait until you yank away potential returns from the people putting up the capital for all those loans," he warns.

This neglects the fact that the government can't force lenders, loan servicers or MBS investors to make loan modifications. They will only do this if they think it's worse than the alternative -- letting these loans default.

Jayson may have a more valid point when he frets that the HOPE NOW plan may "punish the public" by "artificially supporting a home-price bubble that desperately needs a correction. Historical rent-to-purchase data show just how far home prices need to come down in order to return to mean. That requires a painful drop, and it will happen sooner or later."

That may be true, but the credit crunch has the potential to generate an overcorrection in prices, and a recession that could drag on for years.

Also worth considering is Paul Muolo's column today at National Mortgage News.

Muolo points out some potential complications, including the far-fetched notion that lenders would freeze a 3 percent rate on a pay-option ARM, say, or what they will do if prime ARM borrowers want the same deal their subprime neighbors are getting.

Nobody said it woud be easy.

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