Among the many foolish ideas in Sen. Charles Schumer’s open letter to the Fed Chairman and the Treasury Secretary (and others) regarding the subprime mortgage market, there is this:

Furthermore, the prevalence of unscrupulous lending fueled by the increased appetite for subprime mortgage securitizations has resulted in a growing number of homeowners facing payment shocks as rates reset that could cause them to lose their homes. In order for them to keep their homes, their loans must be modified.

Borrowers face payment shocks (a jump in monthly payments) only when they have taken out a floating-rate mortgage and rates have risen. Why do borrowers ever take floating-rate mortgages? Because, by the accepting risk of a rise in market rates (the risk of a “payment shock”) they get a lower base interest rate compared to a fixed-rate mortgage (and a lower expected present value of payments over the life of the mortgage). With a fixed-rate mortgage, the payment never rises, and if market interest rates drop, the borrower can refinance. The lower rate on floating mortgages is the price the bank pays to the borrower for the value of that option. Is it unscrupulous for a lender to offer both fixed and floating rates on those terms? Securitization, by the way, does nothing to affect that risk-return tradeoff faced by the floating-rate borrower.

Schumer wants borrowers who took lower floating rates and accepted the risk of upward adjustment, and now find rates moving upward, to be relieved of the risk at the lender’s expense: “their loans must be modified”. Senator Schumer nowhere recognizes that if floating-rate loans are prevented from adjusting payments upward, banks would stop offering floating-rate loans. If they are prevented from adjusting payments upward by more than a certain amount, the base floating rate would correspondingly rise toward the fixed rate. Many of the borrowers whose home-ownership he wants to protect would never have become home-owners in the first place.