In the first of this three part series, we noted that those of us with an interest in the history and the workings of the U.S. economy have found an interesting paradox brewing in the wings.  Here's a summary.

            In October, 1907, a bank-owner named F.A. Heinze made a major speculation in the stock market, and it failed.  When the news got it, it caused a run on his bank by depositors who were worried that his financial problems may end up being theirs as well.

             It's known as the Panic of 1907.

            In Part One of this series, we related the story of how financier J.P. Morgan dreamed up and promoted a plan that quickly solved the Panic of 1907, and how it now looks as though U.S. Treasury Secretary Henry Paulson is trying a Morgan-esque scenario to resolve the latest panic, the one 100-years later that's being caused by the sub-prime loan meltdown.

             Sub-prime loans are hybrid instruments.  The format was not only dreamed up for the first time in recent years, but the loans were issued and sold in startling numbers, especially when you consider there was no experience history.  And to the naked eye, they looked like a formula for trouble.

            The problem we are now facing is that a huge number of the sub-prime mortgage loans were not only made to people whose credit and assets would not normally sustain the loan approval of a lender, but the loans were made with so-called teaser rates.

            Teaser rates are interest rates that start out artificially below the market, but within a short time become significantly higher, leaving to question, will the borrower be able to pay the new, adjusted payment amount when it occurs?

            In 2008, more than $350,000,000,000 (that's three hundred, fifty billion) of sub-prime loans will adjust to the higher rate.  And that means that several hundred thousand borrowers will see their mortgage payments rise by hundreds of dollars a month.

            Left as they are, most of the sub-prime borrowers won't be able to salvage their homes.  Refinancing will bring no relief, even if it is available to them, because the current rates are similar to the rates their sub-prime loan is scheduled to adjust to.

            And because there are so many of them scrambling on top of a housing market that cheap money drove to become overbuilt, we are seeing sharp declines in home prices, and that will continue for awhile.  So they won't be able to sell them for what they owe on them. much less when commissions and closing costs are added.

            So Secretary Paulson's idea sets up a system that puts these sub-prime borrowers into three categories:  those whose credit confirms that they will be able to sustain the higher monthly payments when the rates reset; those who can continue to pay the current teaser payment, but won't be able to when the rates adjust to the higher amount; and finally, those who can't afford the teaser payment amount much less the planned adjusted rate.

            Only those in the second group can expect help, and that's only if their sub-prime loan rate is set to rise on or after January 1, 2008.

            The Paulson plan is quite simple.  It will give those borrowers (the ones in the second group) five years more at the teaser rate with the hopes that by then the housing market will have recovered so that those borrowers will be able to squirm out of the obligations.

            The question many professionals as well as the man on the street asks is why did the lenders need Secretary Paulson to come up with what is such an obvious plan?   After all, lenders know that their chances of losing money is far less when they renegotiate a workable plan with an in-trouble borrower than it is when they foreclosed the borrower's house.  And the guy on the street has reasoned this out himself.

            Here are the three most important ones:

• There are so many of these loans that are in trouble that the companies servicing them don't have the personnel resources to work them on a case by case basis.

• Unlike what most think, the majority of the sub-prime loans are collateral that's backing securities that were sold to investors - individuals, partnerships, trusts and companies - and many of those are domiciled outside of the U.S.  Finding which of them is holding a particular loan would be a nightmare.

• And finally, and of utmost importance, banks working together without the umbrella of the government would bring lawsuit after lawsuit charging collusion, and collusion is illegal.

            In the final part of this three part series, that will be here tomorrow for you to read, I'll tell you what I've concluded and why.

Copyright 2007 - William S. Cherry

All rights reserved

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