Government's new 5-year ARM at 2 percent

Details of the Treasury Department's Homeowner Affordability and Stability Plan were announced today. It's quite an interesting undertaking that seems like it will be good fun for at least the next couple years as stories of abuse and odd goings-on come to light.

There are three basic components - aid for refinancing, foreclosure avoidance, and more support to Fannie Mae and Freddie Mac. It is the middle component, more properly known as the "Homeowner Stability Initiative", that is most intriguing and most likely to be abused in ways that can only be imagined today. Here's how the plan will work:

- The lender will have to first reduce interest rates on mortgages to a specified affordability level (specifically, bring down rates so that the borrower's monthly mortgage payment is no greater than 38% of his or her income).

- Next, the initiative will match further reductions in interest payments dollar-for-dollar with the lender, down to a 31% debt-to-income ratio for the borrower.

- To ensure long-term affordability, lenders will keep the modified payments in place for five years. After that point, the interest rate can be gradually stepped-up to the conforming loan rate in place at the time of the modification. Note: Lenders can also bring down monthly payments to these affordability targets through reducing the amount of mortgage principal. The initiative will provide a partial share of the costs of this principal reduction, up to the amount the lender would have received for an interest rate reduction.

The old days of a maximum 28 percent of income toward servicing a mortgage have almost returned. Over the years, many have been turned down for mortgages because they failed to meet this requirement - it's crazy to think that this figure got as high as 50 or 60 percent a few years back and then, well beyond that, when people started to lie about how much they made.

In the second step above - where government money enters the picture - there is a downward limit of two percent for the mortgage rate which, effectively, creates a lower limit on income for qualifying.

In other words, your mortgage payment won't get reduced to zero if you lost your job.

Here's an example of how it would work for "Family C" who, back in 2006, took out a 30-year subprime mortgage of $220,000 at 7.5 percent, on a house worth $230,000 at the time. Since the purchase, their home's value has fallen 18 percent to $189,000 and their income has shrunk such that their monthly mortgage payment of $1,538 is now 42 percent of their $3,650 monthly income.

Here's how lucky "Family C" gets their mortgage payment reduced by $406.
Here's the part about the lower limit on the new interest rate:

Protecting Taxpayers: To protect taxpayers, the Homeowner Stability Initiative will focus on sound modifications. If the total expected cost of a modification for a lender taking into account the government payments is expected to be higher than the direct costs of putting the homeowner through foreclosure, that borrower will not be eligible. For those borrowers unable to maintain homeownership, even under the affordable terms offered, the plan will provide incentives to encourage families and lenders to avoid the costly foreclosure process and minimize the damage that foreclosure imposes on lenders, borrowers and communities alike. Moreover, Treasury will not provide subsidies to reduce interest rates on modified loans to levels below 2%.

In the first part of the passage above, it's not clear how they'll determine if it makes more sense to modify the loan or to foreclose, but the two percent lower limit is very clear.

You can just see some of the possibilities here where people will figure out what they need to do to get their income down to that two percent rate - it will usher in a whole new wave of "liar loans", only this time people will be wanting their income to show up on the paperwork at a lower level.

Most importantly perhaps, this sets up a whole new wave of mortgage rate resets in five years as all of these loans revert to market rates which are sure to be much higher than the temporary rate.

This is, effectively, a government subsidized 5-year ARM with rates as low as 2 percent.

My, what progress we're making...