INVESTORS CHEER UNCLE SAM RIDING TO THE RESCUE, THEN RECONSIDER
Since the peak of the market in the middle of July, there have been three market rallies, and the catalyst for all three was the expectation of a policy response from Washington - not any improvement in economic data or the fundamentals. As the chart shows, there was the Fannie rally, the Fed rally, and the FHA rally - all of which were short-lived. We continue to find many investors are convinced that the government (which is not a single autonomous actor) will somehow reverse the vicious cycle of higher delinquencies, tighter credit conditions and lower home prices before prices fall much further and inflict serious damage to the broader economy. We believe this optimism in a government rescue is misplaced. There is very little the federal government can do about the fact that a substantial number of borrowers cannot afford to pay back their loans.
Resets Are Not the Cause of the Subprime Meltdown
It is a myth that rate resets have been driving the subprime delinquencies. In fact, the vast majority of subprime mortgages that are delinquent are still paying below-market teaser rates and have not reset. It is not the interest rate that is burying these borrowers. Instead, it is the fact that even with a low rate they are paying close to half of the gross incomes on their mortgage payment. Whatís more, nearly half of them made up their incomes, so their true debt-to-income is actually much higher.
Here ís why this is important. If rate resets have not played a significant role in the subprime debacle so far, then it is clear that a loan restructuring program won't help the borrowers currently falling behind on their mortgage payments. These loans cannot be paid back using any reasonable interest rate. In many cases, the borrower simply has too much debt. (And this problem is not confined to subprime borrowers.) Given these facts, it is clear that no government program, other than a gigantic taxpayer bailout that forgives a substantial portion of their debt, can prevent these borrowers from falling into foreclosure (or the lenders can modify the loans and take a significant write down).