WASHINGTON — A coalition of major banks with exposure to problem subprime mortgages is finalizing a plan to freeze hundreds of thousands of adjustable-rate home loans at low introductory rates. That would prevent the loans from adjusting to much higher rates, which could trigger mass defaults and foreclosures.
Should subprime ARMs reset, many homeowners could be forced into costly foreclosure proceedings that could prevent a rebound of slumping local housing markets and spread to other industries, potentially even tipping the economy into recession.
The coalition met Thursday at the Treasury Department and briefed Treasury Secretary Henry Paulson and federal banking regulators on their progress toward creating an industry-wide approach to subprime loans, mortgages given to borrowers with weak credit.
"Treasury was encouraged by the progress we heard from mortgage-industry participants," said Jennifer Zuccarelli, a Treasury spokeswoman.
The rescue package targets adjustable-rate subprime loans for owner-occupied homes, not loans for investment properties. Eligible homeowners must be current on their payments and face costly resets that they can't afford. How they must prove that they can't afford the higher rates hasn't been revealed.
The plan would be voluntary for lenders, but the banks involved in the discussions hold, directly or indirectly, about four out of every five subprime adjustable-rate mortgages, or ARMS.
The banks' plan recognizes that, absent a proactive move, many subprime ARMs could reset next year to 12 percent or more from current rates of 7 percent to 9 percent.
"I think there is a basic assumption here that there is money that is going to be lost one way or the other," said Wayne Abernathy, the executive director of financial institution policy at the American Bankers Association.
"I think there's a realization among investors that maybe getting some interest, even if it wasn't the interest (rate) envisaged under the terms of the mortgage ... is better than having to go through the foreclosure process," said Nigel Gault, an economist with forecaster Global Insight. "Stemming the number of foreclosures may reduce the severity of the overall downturn in the housing market."
One key point in the talks has been to limit who can get a workout.
"The test is to come up with a plan that doesn't spook the secondary market," said Abernathy, who wasn't at the meeting but is familiar with the issues.
Traditionally, banks held home loans on their books. But over the past decade, there's been an explosion in the secondary mortgage market, where home loans are sold and bundled together with other loans to be sold again as mortgage bonds. This process is called securitization, and this market has seized up amid concerns that massive foreclosures are coming that will slash the bonds' value.
Paulson and other regulators met with representatives from Washington Mutual, Wells Fargo & Co. and Citigroup. The meeting brought together loan underwriters, mortgage servicers who place the loans into the secondary market and the trade group American Securitization Forum.
The workout concept was aided earlier this year by the Securities and Exchange Commission, which held that loan servicers could work with borrowers before they got into trouble in order to preserve the integrity of the bundled mortgage bonds.
Wall Street analysts believe there are roughly 1.5 million subprime loans resetting next year, with a value exceeding $350 billion. Federal regulators believe there are 2 million "exotic" ARMs that have low introductory teaser rates and that 30 percent of them are already behind on payments. The number of homeowners who could benefit from the rescue package remains unclear.
Community activists working with homeowners complain that banks have been slow to help individuals with workouts.
"It's nowhere near satisfactory," said Paul Dylan, a community organizer in Minneapolis for ACORN, a national housing advocacy group. ACORN has pushed local and federal government officials to pressure banks, but it was only recently that the federal government began paying attention to the pending resets.
Federal Deposit Insurance Commission Chairman Sheila Bair suggested a five-year freeze on the resets of certain exotic ARMs. Paulson initially rejected that idea. John M. Reich, the director of the Office of Thrift Supervision, has suggested a minimum three-year freeze on resets.