Treasury's Subprime Plan and the Danger of Tactical Delinquencies

Of all the ideas floated to help solve the subprime mess, I never really believed that Sheila Bair's plan to simply lock in teaser rates would be the one to gain traction. As I said when it was first mooted, it has some major weaknesses:

This is far from being a perfect solution. It rewards the foolhardy borrowers who plumped for the lowest teaser rates over those who ensured that they could afford their mortgage payments indefinitely. It also encourages pretty much anybody with a subprime ARM to default on a mortgage payment or two, which can't be a good idea.

But that was well over a month ago. Since then, the plan has obviously been refined to take those obvious objections into account, right? Right? Er, not so much. In fact, in an echo of the still-not-launched Superconduit, this idea seems to have found its way into the press with most of its details still to be worked out.

I trust that someone, somewhere, is looking into the effect that this might have on securities prices. The WSJ treats bondholders as some kind of homogenous mass:

Among the holdouts have been investors, who typically hold securities backed by mortgages. If interest rates are frozen, they would lose the potential benefit of higher payments. But investors have cautiously moved toward cooperation, likely on the grounds that it's better to get some interest than none at all.

In reality, it's almost certain that some bondholders would benefit from this scheme, while others would lose out. My intuition is that the plan would help out junior bondholders at the expense of senior bondholders, although it probably differs on a case-by-case basis.

I also hope that Treasury has looked in some detail at the qualification mechanism for this scheme, which could carry a host of unintended consequences. That said, something very similar has already been launched in California, so I hold out a tiny hope that someone, somewhere, has done some degree of due diligence on the way these plans are constructed. The last thing anybody needs right now is a whole new wave of tactical delinquencies designed to bring loans into the qualification zone.

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