Wall Street critics are coming out in force against President Bush’s proposal to prevent subprime mortgage lenders from foreclosing on some homes.

Chief among the complaints is the notion of moral hazard — that borrowers who voluntarily took on too much risk are now being rewarded for their bet. There is also growing concern that the president’s proposal will have a chilling effect on the bond market, with investors now worried that the government could step in and alter any type of investment contract just to stave off losses. In addition, there are questions as to the practicality of the plan, which enables lenders to freeze the interest rate on a certain type of subprime loans for five years, such as how to determine whether a borrower is eligible for this freeze.

“Without question, the Bush administration’s mortgage rescue plan will exacerbate, not alleviate, the problems in the housing market,” the president of Euro Pacific Capital, Peter Schiff, wrote in a note to clients. “This is a massive giveaway — every person with a subprime loan is going to do whatever he or she can to qualify for this interest rate freeze,” he said during an interview.

The plan presented yesterday by President Bush is designed to help borrowers with subprime adjustable-rate mortgages that can afford the current “teaser” rates — the initial low interest rates offered by lenders — but will not be able to make their payments once these loans reset higher. Close to 2 million of these subprime ARMs, as they are known, are scheduled to reset by the end of 2009. According to Credit Suisse Group, 775,000 homes with $143 billion worth of mortgage debt are expected to go into foreclosure over the next two years.

In addition to freezing rates, the program, which was agreed upon by an alliance of banks and financial industry lobbyists, including Citigroup and JPMorgan Chase, also allows borrowers to refinance into new private mortgages or obtain loans from the Federal Housing Administration. Only a select group will be eligible: Borrowers must have rates scheduled to adjust between January 2008 and July 2010, they must be current on their payments, and they must be no more than 60 days late in the past year. Borrowers also must have low credit scores, be full-time employees, and occupy their homes.

“There is no way to forecast how this plan will affect people, but if they think it will be a cure-all, that is not the case,” a lawyer at Cullen & Dykman, Christopher Palmer, said.

Critics worry that investors might interpret the plan as government intervention, which could weaken demand in the bond market.
“It is becoming tremendously important that the perception not be created that the government is changing the loans,” a partner at the law firm Stroock & Stroock, Allan Krinsman, said. “If that were to become the case, foreign investors may decide that investing here entails more legal risk than it is worth.”

Already, the ratings agency Standard & Poor’s issued a report yesterday saying that freezing subprime borrowers’ interest rates “may impair the ratings” of mortgage-backed securities.

Still, Mr. Bush’s plan was clever in its solution to a tricky problem, Mr. Krinsman said. Because it would have been impossible to gather all the bondholders who actually own the subprime loans to collectively make such changes as freezing the rate, the industry group backing Mr. Bush’s plan found another way. The banks that service the mortgages have the authority to do so in accordance with standard industry practice. Therefore, the industry group that backed Mr. Bush’s proposal represents more than 80% of loan servicers, “so all of a sudden, with the majority of the industry now in agreement, it has become standard industry practice,” Mr. Krinsman said. Therefore, it is not that the government interfered with the structure of these subprime loans, but rather that Mr. Bush’s plan is now standard industry practice.

Putting the plan into play may not be as easy as it sounds. “If I were a bondholder of these mortgages and I was entitled to a reset, I would be very upset if any cap was imposed,” the chairman of the real estate practice at the law firm Greenberg Traurig, Robert Ivanhoe, said. “This raises constitutional-type taking issues.” Several critics believe that these bondholders could sue, forestalling the implementation of the plan.

A strategist with Ten Asset Management, Paul Kedrosky, called Mr. Bush’s proposal “a largely political solution to an economic problem.” It will just delay the number of foreclosures, forcing the next administration to resolve the problems. As for its practical applications, Mr. Kedrosky called it “nightmarish. We don’t have adequate documentation of what these subprime borrowers actually earn, so we will have to requalify people for this plan, and how do you do that over thousands and thousands of loans?”