Real Estate

New $20B subprime bailout on the table

Senator Chris Dodd proposes setting up a fund that would buy defaulting subprime mortgages and restructure loans for borrowers.

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By Les Christie, staff writer

Senator Chris Dodd.
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NEW YORK ( -- A proposal to bail out subprime mortgage borrowers who are at risk of foreclosure was floated at a Senate Banking Committee hearing Thursday.

Senator Chris Dodd, the committee chair, said he is working to create a Home Ownership Preservation Corporation, which would purchase mortgage securities that are backed by at-risk, subprime loans from lenders and investors.

This corporation would give these lenders and investors a better price for the securities than they would get if the properties backing them were put through foreclosure.

Additionally the loans on these properties would be restructured so that borrowers could afford the new payments and remain in their homes.

Lesser of two evils

Although economists believe that the mortgage backed securities would sell at a steep discount to their original values under this scenario, they contend that investors would still recoup more of their outlay this way, rather than going through the expensive foreclosure process.

Borrowers could see their monthly costs drop dramatically.

According to today's testimony, the fund might require $20 billion to $25 billion in seed money from taxpayers and, after that, it should self-fund.

Dodd said his proposal is supported by both ends of the ideological spectrum. He pointed out that two of the witnesses testifying on Thursday in support of this bailout - Michael Barr, from the progressive Center for American Progress, and Alex Pollack, with the conservative American Enterprise Institute - are usually on opposite sides of economic issues.

But there was dissent from members of the Banking Committee. Senator Bunning, R-Ky., said "Government meddling could make matters worse."

Senator Bob Corker, R-Tenn., was concerned about the "moral hazard" of rewarding borrowers' risky behavior.

But in his testimony, Barr insisted, "This is not a bailout for investors and speculators. Investors would take a hit in exchange for liquidity and certainty."

Barr added that they'll get back much less than what they paid for the securities, and pointed out that only owners who occupy their homes will be eligible for loan modification.

"Ninety percent of the time, [government] intervention is not a good idea," said the more conservative Alex Pollock, who would generally prefer market corrections to address a problem. "But we're in the 10 percent of the time when it is needed."

A big step

Mark Zandi, chief economist for Moody's, suggested a plan similar to Dodd's in early December, and agrees that it's a big and very complicated step. "But we have to prepare for the possibility that something like this will be necessary," he said.

And he contended that any bailout must be made with taxpayer money. "It has to have the triple A credit of the United States backing it," he said.

The biggest problem facing housing, according to Zandi, is that the market is frozen, because investors who buy mortgage-backed securities have abandoned that market. That's created a liquidity squeeze which has made it difficult for even well-qualified borrowers to obtain a loan.

Zandi thinks the fund should buy existing mortage-backed securities in an auction-type process, which would immediately establish what those securities are really worth.

"As soon as there's a price [for the securities], there's a market," Zandi said. "Everyone can then start appropriately valuing what's on their books."

Jared Bernstein, an economist with the Economic Policy Institute, a progressive, Washington-based think-tank, agrees. "Auctioning the debt to discover its true price might be ugly but it's the way to go," he said. "You can't hit bottom until transparency is back in the system and this will help bring it back."

Bernstein added that such a plan is not unprecedented. "There's a long history of the government providing precisely this kind of help for people facing foreclosure," he said.

The American Enterprise Institute's Pollock compared the Dodd proposal with the Homeowners Loan Corporation, which operated during the Great Depression in the 1930s.

Pollock also conceded that the program is not without flaws. It could reward some people who bought more home than they could afford, while leaving more responsible borrowers unaided.

Might some of these people be tempted to stop making mortgage payments for a couple of months in order to get a government-sponsored cheaper loan?

"You're going to have some people going into default to get into the government program. That's part of the cost you have to reckon with," he said.

There are currently several government-backed efforts underway to combat the housing crisis.

The stimulus package now before Congress would raise the caps on loans that Freddie Mac and Fannie Mae can purchase in the secondary markets to create more liquidity, while a hike in FHA caps would do the same. Meanwhile,Federal Reserve has moved swiftly to cut interest rates, which will also put more money into credit markets.

"All these efforts may not be enough," said Zandi. "[But this bailout] will cost taxpayers a lot less money than leaving the market in a deep freeze." To top of page

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