Federal Bailout in the Works? Could Modified Option ARMs be the Savior?

Ben Bernanke, our beloved Federal Reserve Chairman, wrote a letter to Senator Charles Schumer (D-NY) that was released today. In the letter, Mr. Bernanke wrote that the private sector and Congress should create new, affordable mortgage products that would help some homeowners refinance their mortgages and keep their homes. Sounds like a bailout is in the works to me.

The letter really doesn't add anything new to the markets, but rather reemphasizes what the Fed has been thinking since their statement after the August 17th cut in the discount rate. The letter is being toughted as a "bullish" letter by bond strategists and shows Bernanke being sympathetic to concerns expressed strongly in the financial markets.

Mr. Bernanke is scheduled to speak on housing and housing finance on Friday, the same day the Fed's favorite measure of inflation (Core Personal Consumption Expenditures or PCE) is released. Coincidence? Maybe, maybe not. Chances are that the Fed Chairman will hint the direction the Fed will go at their next meeting, September 18th, though most already expect a 25 basis point (.25%) rate cut.

In the letter, Bernanke states the need for creative thinking to get the nation out of the subprime mess. He stated that it might be worth considering whether the private and public sectors, either separately or collaboratively, could help the situation through the development of a broader range of mortgage products that are more appropriate for low and middle income borrowers, including those seeking to refinance.

He goes on to mention the need for these products to be designed to mitigate the risk of payment shock and be transparent with respect to their terms. He then proceeds to hint the need for features that improve affordability, such as variable maturities or shared appreciation provisions.

Interestingly enough, the features he mentions in regards to "affordability" and to "shared appreciation" sound very much like the "exotic" loans that everyone claims are leading to the increase in foreclosures and the current liquidity crisis. Option ARMs easily fit in the category of "shared appreciation" and "affordability" as they provide reduced monthly payments and the negative amortization can be considered as playing a part of appreciation.

So, the reality is that even Bernake realizes (or so it would seem) the benefits for Adjustable Rate Mortgages, Interest Only programs, and even a modified version of the Option ARM programs. Obviously tighter margins and other "payment shock" preventative measures will need to be incorporated, but overall the products can prove very beneficial if used properly.

Some other things he mentions are that Congress should consider legislation (they already are) that would reform the FHA (Federal Housing Administration) allowing that agency to fill in the gap for the subprime lenders falling by the wayside. Since the FHA has tighter lending standards, not everyone will qualify, though changing the FHA guidelines to allow those late on payments would help.

Another Congressional reform potentially needed (also being considered) is that of Fannie Mae and Freddie Mac oversight. A reform could allow them to buy more mortgages as a way of injecting more liquidity into the markets. They may even be allowed to buy mortgages greater than $417,000. Since they are the "conforming" market and have not been hit by the credit crunch, changes in these limits can bring increased stability and affordability to the markets.

As you can see, the government is working to "bailout" the mortgage industry and homeowners who are in trouble. And, believe it or not, those "exotic" mortgages may be part of the solution, at least for the short term.