Paulson Friday said the mortgage industry was working with the Treasury on a broad plan to help save the homes of subprime borrowers with adjustable-rate mortgages who cannot afford higher payments as their interest rates reset in coming months, but who otherwise could afford to stay in their homes.
The plan's details are now up to the mortgage industry and investors, the two groups that will have to absorb its costs.
"The message is that everybody has to get on the bus," the source said of Paulson's directive.
Details over which mortgages would be considered for an automatic interest rate freeze of five to seven years are still sketchy. The source said that initially, only subprime loans with two- or three-year periods of low "teaser" rates would be considered, but more traditional subprime loans with longer fixed-rate periods could also be modified.
A shorter freeze period was initially considered, but Federal Deposit Insurance Corp. Chairman Sheila Bair pressed in the negotiations for a five- to seven-year freeze. Bair was the first federal regulator to propose a broad rate freeze as California negotiated a similar deal with several top mortgage lenders in the state, hard-hit by the housing downturn.
Estimates of mortgage resets vary. Federal Reserve officials estimate that 2 million mortgages face resets and as many as 500,000 of these could lose their homes.
Deutsche Bank said in a report Friday that the population Paulson's plan is aimed at -- owner-occupants with at least some equity and facing their first reset -- comprises 1.2 million loans valued at $258 billion, or one third of outstanding "first-lien" subprime loans.
A particularly thorny problem is the threat of lawsuits from investors who bought securities backed by the mortgages.
These investors were promised a certain yield, based on the expected hikes in interest rates, and an automatic freeze without reviewing individual loans may give them grounds to sue mortgage servicers.
"You might end up benefiting borrowers who are perfectly capable of making payments," said Ajay Rajadhyaksha, head of fixed-income strategy at Barclays Capital in New York. "I'd be surprised if every investor out there agreed to give servicers carte blanche" to freeze interest rates, he said.
Mortgage servicers asked for support from federal regulators, including the Office of Thrift Supervision and the Office of the Comptroller of the Currency, to help them deal with any legal backlash.
The American Securitization Forum, a trade group that represents large mortgage investors such as pension and mutual funds, said Friday it could "support loan modifications in appropriate circumstances."
A streamlined approach to loss mitigation "will ultimately help servicers manage their responsibilities in a changing market, while appropriately balancing the interests of borrowers and investors," Tom Deutsch, ASF deputy executive director, said at a housing hearing in Los Angeles.
While agreeing on mortgage changes on a large scale is difficult, it has been done before. After Hurricane Katrina in 2005, for instance, housing finance giants Fannie Mae and Freddie Mac provided prolonged forbearance that let devastated Gulf Coast homeowners miss loan payments.
"This comes up every few years -- a tornado in the Dakotas or flooding somewhere. We would be able to modify the loans a bit. The investors hated it but the politicians loved it," said a source familiar with how Fannie Mae and Freddie Mac have made allowances for stressed communities in the past. "It's not easy, but it can be done."