October 19, 2007
New York Times
By Sheila C. Bair
Washington

THERE have been many proposals to deal with the problems in the mortgage market. But the best place to begin is by looking at the poor lending standards and weak consumer protections at the root of the problem — in particular, the troubling loans called 2/28 and 3/27 subprime hybrids. They have starter interest rates of 7 percent or more for the first two or three years, and "resets" that raise rates to as much as 12 percent, causing monthly payments to increase by at least 30 percent.

When housing prices were rising, borrowers could sell or refinance their homes to pay off the loans before reset and avoid crippling monthly payments. But this year, as prices have dropped, more than $150 billion in these loans have undergone reset, and an additional $300 billion will do so before the end of 2008.

Merrill Lynch estimates that if home prices decline by just 5 percent, a quarter of subprime loans may enter default, resulting in losses of almost $150 billion.

A government bailout is not the answer. Bailouts erode market discipline, raising the likelihood of repeat episodes. And efforts to expand refinancing options will help only those borrowers who have enough equity to refinance.

What happens to those who are unable to refinance and cannot afford the rate resets? Most of their loans are managed by firms called servicers. Typically, servicers sit back and wait for people to default, then foreclose and sell the properties. But in today's troubled housing market widespread foreclosures will only maximize losses for servicers.

Renegotiating terms loan by loan is too costly and time consuming. Servicers have modified only one percent of these mortgages that reset in early 2007.

So subprime servicers should take a more standardized approach: restructure all 2/28 and 3/27 subprime hybrid loans for owner-occupied homes in cases where the borrower has been making timely payments but can't afford the reset payments. Convert these to fixed-rate loans at the starter rate.

This would be no bailout. These borrowers would still be required to make their monthly payments — at rates higher than what prime is today. Billions in savings would be generated by avoiding the administrative, legal, marketing and other costs of foreclosure, which can run to half or more of the loan amount. And avoiding foreclosure would protect neighboring properties and hasten the recovery of markets burdened by an excess supply of houses.

The mortgage crisis is growing, and the mortgage industry has the ability to help solve much of it on its own. Subprime borrowers need a better deal — one that they can afford.

Sheila C. Bair is the chairman of the Federal Deposit Insurance Corporation.