The Issues: Another Government Refinance Program?
The New York Times is reporting that the government is seriously contemplating a broad-based refinancing of mortgages guaranteed by the two GSEs, Fannie Mae and Freddie Mac, in an effort to reduce payments by those borrowers who currently cannot refinance either due to negative equity in their homes or due to their own credit constraints. This idea was originally raised in 2008 as the housing crisis got underway and has been viewed by its proponents as a way for the government to provide a stimulus by putting billions of dollars in the hands of consumers and relieving the default and foreclosure crisis that is hampering housing recovery without any cost to American taxpayers. The initiative would be beneificial to borrowers and provide a much needed economic stimulus at no direct cost to the government. However, the costs will be funded by investors in agency MBS and the operational burdens and expenses will be borne largely by the GSEs. Opponents to these sorts of provocative proposals could also argue that no direct wealth creation is being achieved as a result and the benefit to borrowers is the result of wealth transfers from investors of the mortgage backed securities. The rumor of government action was enough to drive down premium prices in agency MBS over the last week. The unexplored consequence of the government effectively modifying contractual agreements between borrowers and investors could reasonably create a precedent which, in the long run, may ultimately increase the cost of credit.
This contemplated wealth transfer is in parallel to the one that results from quantitative easing (QE). Both the QE of 2008 and QE2 of 2010 have kept interest rates extremely low and in the current environment of short term rates close to zero with inflation getting close to 2%, the savers are once again seeing their wealth being eroded. The benefits of QE as well as programs such as an automatic refinancing that are being debated arise clearly from the multiplier effect of spending that arises from excess cash in the hands of consumers. However, all such exercises begin with significant wealth transfers from savers or investors to the borrowers. At some point the diminishing returns from the multiplier effect will be challenged to compensate for investor losses.
The overall beneficial impact of an automated refinancing program for borrowers, credit risk takers and eventually the housing market and the economy make a compelling case provided the investors are also partially compensated. In the case of portfolio lenders the gains from credit enhancement through this exercise go directly to them and it would be best to start the refinancing program through those lenders. Private lenders have developed innovative products and services that can make the execution of a wide scale refinance program no more difficult than directing borrowers to a web site and promoting them to click a button.
There are a significant amount of mortgages held as whole loans. From FDIC data, all banks and thrifts as of 6/30/2011 held roughly $2.4 trillion of 1-4 family residential mortgage loans on their balance sheet– this does not include credit unions, life insurance companies, or other holders of whole loans. In addition, the GSEs hold several hundred billion dollars in whole loans. These loans are at risk as borrowers that can refinance at a lower rate will, most likely with another institution (average borrower retention rates are 30%), and those who cannot because their house is under water are increasingly likely to walk away.
The failure of the myriad of attempts to stem the tide of foreclosure has been widely publicized-borrowers who failed to make their payments were “rewarded” with principal forgiveness and modifications, while those who watched their equity evaporate were forced to sit on the sidelines, unable to take advantage of the historically low rate environment even though they played by the rules, often opting to just walk away. Banks and investors are sitting on assets with deteriorating value and exposure to torrential run-off with few options. The burning question remains: How do we begin to right the ship? Can it be done without a government (read: taxpayer) subsidy?
By rewarding borrowers who have made timely payments by enabling them to refinance without the cost, hassle and time of the traditional mortgage process, numerous problems are solved: (1) Lower monthly payment so borrower can and will more likely remain current and in the home; (2) Increase in customer retention for the bank; and (3) Increased interest income and reduced retention cost.
This option exists in the market and could be applied to loan portfolios today with little cost to the bank or the consumer. Imagine if a borrower, who now has a mortgage that is 125% of the home’s value and an interest rate of 6.5%, could click a button and reset their rate to current market (or the proposed 4%) with no appraisal required. Imagine if a bank, evaluating these loans in their portfolio and projecting the likelihood of continued performance as dismal, could add this option for their customers, mitigating these losses and creating a customer for life. This creates a compelling scenario without a zero-sum game as all constituents reap some benefit.
The likelihood of a one-size-fits-all panacea is remote, but this is a potential solution for a segment of the impacted market. Once this feature is applied successfully to loans in portfolio, it could be revised or retooled for application to MBS pools. If this refinancing program were to go forward with the GSEs it would face issues similar to those encountered by the HARP program. The streamline program implemented by the GSE’s under HARP saw low pull through rates month after month compared to the eligible population. Servicers faced operational challenges and were hesitant to devote significant resources for a program with an impending sunset date. In addition, borrowers with LTV up to 105% saw better pull through rates than those greater than 105% and up to 125% primarily due to their TBA eligibility. Going forward it would make sense to incentivize the servicers by paying them for additional one-time resources through a spread above current rates that is offered to the underwater or credit impaired borrowers. In this historically low rate environment, a slightly higher rate offered to those borrowers would still be extremely advantageous compared to their current rates. In addition, an extension of the eligibility date from May 2009 to a more current date, removal of the 125% LTV cutoff and further extension of the sunset date for the HARP program from the June 2012 cutoff would go a long way towards inducing the servicers to devote resources for streamlining their operations. Other issues such as rep and warrant exposure will continue to be impediment and will need to be addressed as the program is monitored and assessed over time.