Fighting Fear With Information

By Jack Guttentag

The mortgage world has suddenly become very frightening to many people who have no real reason to be frightened.

Their loans are in good standing, and they are not having any trouble meeting their payments. Still, they are in distress -- in large part because so many around them are in distress. Fear is contagious. The only antidote I know is good information.

One thing that people suffering from mortgage fright often forget is that a mortgage loan is a contract between two parties and cannot be violated by either without the permission of the other. If the loan is sold, the purchaser replaces the originating lender as the contracting party and is subject to the contract in the same way. If the servicing of the loan is sold, the servicer as the agent of the owner is required to abide by the terms of the contract, and the same holds if the loan is placed in a pool as collateral for a mortgage-backed security.

The first two letters below are from borrowers who do not have a problem with their mortgages but are distressed about what might happen to cause them a problem. The third is from a borrower in a more difficult position.

Q: Can whoever owns my mortgage demand immediate repayment of the balance? I know it doesn't make sense, but crazy things seem to be happening.

A: Mortgage contracts do not give the lender the right to demand immediate repayment. Balloon loans require repayment at the end of the balloon period, but that is stated in the contract. Fortunately, there are not too many balloon loans around.

Even if lenders had the legal right to demand immediate repayment, they wouldn't do it because it would only generate more foreclosures. For the same reason, borrowers with balloon loans in good standing who are unable to refinance anywhere else will find that their existing lender would prefer to refinance rather than to foreclose.

Q: When my adjustable-rate mortgage adjusts next year, the new rate should be the one-year Treasury rate plus a margin of 2.5 percentage points. Last year, my lender replaced the Treasury rate on new loans with Libor. Because of the crisis, Libor is now much higher than the Treasury. Can my lender switch my ARM to Libor when my rate is adjusted?

A: No. The rate is adjustable, but not the index used to calculate it. Your ARM contract stipulates the index and its source, and the only circumstance in which a different index can be substituted is if the specified index is no longer available. The different Treasury indexes used for ARMs are compiled by the Federal Reserve, and there is zero likelihood that they will disappear.

I wish I could answer the next letter with the same degree of certainty.

Q: We bought our house last year with 100 percent financing. Now it is worth $40,000 less than we owe. I don't know what to do. Do we keep making mortgage payments, or do we stop? A friend has advised us to lock the door and send the key to the lender, but that doesn't sit well with me. We've always met our obligations and have good credit. What do you advise?

A: This letter is typical of many I have received from borrowers who are "upside down" -- they owe more than their houses are worth. I have a lot of trouble dealing with it because, in good part, it is a moral issue.

One part of me says that when you borrow money, you should pay it back if you can. During the many years when house prices were rising, I never once heard of a mortgage borrower offering to share the capital gain with the lender. There is no justification in forcing the lender to share the capital loss.

Another part rejoins that few of the people who are upside down today enjoyed a capital gain on previous homes that they owned. Further, the borrower's major obligation is to his family, not to his lender. If the financial gain from letting the house go to foreclosure more than offsets the pain of having his credit trashed and searching for a new place to live, then that is what the borrower should do.

There is an economic dimension to this quandary. If those who are upside down could be assured that house prices have hit bottom and within a year or two will be right-side up, there is little doubt that most would choose to stay the course. Unfortunately, no economist in good conscience can provide such assurance today.

Finally, there is a policy dimension. Upside-down borrowers would be encouraged to keep going if they had some reason to believe that the government would help them get right-side up. Right now, the prospects for this are extremely murky, but don't write it off just yet.