Regulation

Teaser Freezer Burn

Pretending bad loans aren't bad loans fixes nothing

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Given the amazingly complex world of high finance—full of derivatives, hedges, and tranches—Treasury Secretary Henry Paulson last week hit upon a stunningly simple plan to fix the nation's subprime mortgage mess: Lie. And don't just lie, but get everybody together and agree to lie, thereby making the lie become truth.

The fiction Paulson and the major banks are promoting is that extending the low "teaser rates" initially offered to many subprime borrowers fundamentally will help them and—here is a big lie—transform them from bad loans to good.

Put another way, if the problem of bad subprime mortgages was caused by delusion over lending risk, this latest solution enshrines delusion as the defining characteristic of the American banker—backed by a facile enabler in Uncle Sam and his trillions, of course.

Financial risk analyst Chris Whalen calls Paulson's plan "appalling." Whalen's Institutional Risk Analytics zeroed in on the banks' unwillingness to acknowledge risk in their lending portfolios back in 2005. Now he sees the so-called "teaser freezer" plan as an attempt to put Humpty Dumpty back together again and build a floor underneath uncertainty in the financial sector. Except that he estimates around one-third of teaser borrowers will default anyway, a measure of just how dumb lenders are in handing out loans to people with bad credit.

"It is probably in their best interest to walk away. They have no equity," Whalen says of the hapless borrowers.

The possibility of their underwater borrowers actually taking a walk terrifies the banks, however. Banks would have no choice but to write down and make real phantom losses lurking just off their books. What to do? How about pretending that the loans aren't actually bad. How do you do that? Pretend that the borrowers can pay them back. How do you do that? Pretend the teaser rate is the real rate. Presto, problem solved.

At this point, some adult would ideally step in and say, "no, that's fraud." But clearly Treasury is not that mature. And it appears the Fed has resigned itself to some form of greater idiocy coming out of Congress on the subprime front that maybe, just maybe, the teaser freezer can head off.

However, the stubborn fact remains that banks will lose money on teaser rates. Regulators and investors both know this. Who exactly are we trying to fool? Besides inattentive voters.

Meanwhile, by allowing big banks to keep their rot off the books, the potential exists for it to continue to spread. Whalen and other experts have wondered for months about losing the ability to price risk, or even recognize it given the complexity of the constructs floating around financial markets. The Paulson fix only exacerbates the problem by continuing to assert that real world constraints do not matter. And the stakes are already high.

"We could lose a money center bank next year," Whalen warns.

Should you duck your head out of Treasury's "let's pretend" camp for a second, one notices that there are major legal obstructions to rewriting millions of loan contracts by federal fiat. Contrary to the wish of some in Congress, mortgage lending is still largely an activity engaged in by two private entities, each of whom assume very specific obligations. This is not a federal program to be tweaked at the margins. Real estate lending contracts are a dozen pages long for a reason. And each contract is different yet just as legally binding, depending on a given state's law. That's right, state law.

It is unclear how federal action to extend low-low teaser rates can square with state lending laws which may require an actual change in the underlying contract. Unless the idea is just to do this all informally, with a notification letter from lender to borrower and as long as federally chartered banks get approval from their federal regulators to pretend.

After all, what is a little lie between friends?

Contributing Editor Jeff Taylor is a writer in Charlotte, North Carolina.