Here’s my opinion on the new Bush’ plan to freeze ARM rates for subprime borrowers. First of all I’m not against this plan at all, maybe I will even support it if I see that it is not falling apart, which is very likely.
What I definitely like is that budget money (what I’ve paid in taxes, and I’m paying quite a lot of taxes) are not involved. Second I like that the investors are supposed to pay the bill, not the communities, homeowners or whatever little people there are around. If investors invested money I suppose they don’t really need those money and we can plunder this wallet a little bit.
The only problem with the plan is that it may turn out that investors may try to refuse to be plundered. The whole idea of tranched CDOs is that they have multiple layers of protection. First layer is that mezzanine slices of CDO are protecting the senior debt. Second layer is that every slice is protected by CDS. The first protection is for the loan life, the second protection is for the first 5 years.
If the loan is modified the way that the default is artificially delayed by 5 years the CDS protection will expire and thus the tranche must be downgraded to reflect this elimination of protection. Bondholders will not like this and they will try to sue everybody and everyone to declare every modified loan default and to trigger the immediate insurance payment. Insurance holders will counter-sue to declare the loan current and not subject for insurance event. Counterparties will spend a lot of money on lawyers and then some money will change hands. We’ll see what happens.
Update: Looks like I was incorrect about lawsuits