By Edward Pinto – The Federal Reserve continues its efforts to lower interest rates and the administration keeps expanding mortgage refinance programs, all in an effort to promote more lending. One result has been 14 million residential refinances since 2009.

Despite these efforts, the economic recovery has been the slowest since at least World War II. Given the underwhelming impact of taxpayer-funded stimulus, refinancing has become the stimulus of choice. This approach, however, will not address the problems facing our economy or the housing market.

Refinancing stimulus is not free. Every dollar going to a borrower is income taken from a saver. Savings come from retirees, pension funds and families saving for college. To paraphrase Winston Churchill, to create prosperity by redistributing wealth is like standing in a bucket trying to lift oneself up by the handle. What’s more, most borrowers are left with mortgages that will be underwater for many years.

Jobs create demand for housing, not the other way around. While the 14 million refinances have saved borrowers about $28 billion a year, the stimulus effect is weak because income is being redistributed. A more effective policy would be encouraging the private sector to add 280,000 new jobs, resulting in a $28 billion addition to GDP. Better yet, set a goal of 1 million new jobs per year. Start with a revenue neutral reduction in our corporate income tax rate (currently the highest among developed countries), allow the use of our own and Canada’s energy resources, and repeal ObamaCare.

With respect to severely underwater borrowers who have been paying on their mortgages, a narrowly targeted approach that addresses the underwater problem makes sense. There are 1.5 million such Fannie Mae and Freddie Mac borrowers. These borrowers have already been paying their mortgage for an average of five years. Fannie and Freddie should unilaterally modify these loans from their current rate of about 6% to today’s rate of 3.25%.

Rather than reduce the monthly payment, the savings from the lower rate would go to pay down the loan, thereby addressing the underwater problem. This approach could be done quickly on a mass basis with little or no borrower fees. Losses would be reduced for Fannie and Freddie (i.e., the taxpayers). It is fair to bond holders who benefited from a taxpayer bailout. These loans are in mortgage backed securities issued before the bailout.

Proposal for the unilateral modification of non-delinquent severely underwater Fannie and Freddie loans:

Summary:

Fannie and Freddie should provide non-delinquent homeowners with severely underwater loans (greater than or equal to a 120 percent combined LTV today) that they guaranteed prior to their conservatorship a unilateral modification down to today’s rate (from an average of 6.1 percent to say, 3.5 percent), but without any payment reduction (these borrowers have been paying for an average of 5 years). Fannie and Freddie would buy the to be modified loans out of the MBS pool at par.

• Accomplishes the goal of rapid deleverage as these loans would now pay off in 15-18 years.
• Presents little or no moral hazard and could be done rapidly on a mass basis with little or no borrower fees.
• Given the unilateral nature of this approach, the success rate would be quite high – perhaps as high as 90%.
• Given the minimal paperwork required, this effort would accomplish perhaps 1.25 million narrowly targeted modifications without clogging origination pipelines.
• Reduces the losses sustained by Fannie and Freddie (i.e., the taxpayers).
• Fair to the bond holders have no cause for complaint because these withdrawn loans are in MBS that benefited from the direct taxpayer bailout of Fannie and Freddie, a bailout that was not legally required. This follows the legal maxim: those seeking equity must do equity.”

Here’s the math:

This approach helps severely underwater borrowers who have done the right thing and made loan payments for the last 5 plus years get the benefit of a lower rate but keeping the same monthly payment. This way the loan amortizes much faster, helping the homeowner get himself out from under water.

Example:

• Existing 6.0% 30-year loan from Jan. 2007 with a $839 monthly principal and interest payment, an original balance of $140,000, a current balance of $130,000 and a current home value of $100,000 for a 130% current LTV.

– Do nothing: in 5 years, the LTV would be 117% (assumes zero nominal house price change).

– Typical HARP: refinance into a 4.0% 30 year loan with a $132,000 balance ($2000 in financed fees) and a $630 monthly principal and interest payment.

• After 5 additional years, the LTV would be 119% (assumes zero nominal house price change).

– Constant payment alternative: modify[1] into a 3.375% 17- year loan: with a $130,000 balance and an $838 monthly principal and interest payment.

• After 5 years, the LTV loan would be 99% (assumes zero nominal house price change).

Here’s the justification for targeted loan modification:

These severely underwater loans remain in imminent danger of default, with attendant losses to the taxpayers. This is demonstrated by recent research from The Case for Accelerated Amortization (by Alan Boyce, Glenn Hubbard, Christopher Mayer, and James Witkin). Their research shows that 26% (annualized) of those GSE loans with LTVs >125% that were current as of December 2011 were 30 days plus delinquent as of March 2012. This compares to 11% on loans with an LTV of 100-109.99%.

Here’s the expected savings:

The expected savings may be estimated also using data from The Case for Accelerated Amortization.

GSE loans with an LTV >125% have:

1. An expected default rate of 15.78% (based on current terms);

2. Expected losses per borrower of $13,884;

3. An average loan size of $176,000;

4. Thus yielding an incurred loss per loan of 7.9%.

Shortening the term to 15 years reduces the expected default rate to 5.76%, ten percentage points below the current expectation of 15.78%. This 63% reduction in default rate compares to a reduction in default rate of only 10% (from 15.78% to 14.14%) when the rate on these underwater loans is brought down to today’s rate, but with a 30-year term. At the same time, the expected loss per borrower would be $4611, down from $13,884, a reduction of 67%.

If 1.25 million of these underwater loans were modified to a 15- year term, this would result in a ten percentage point reduction in expected default rate (from 15.78% to 5.76%) or 125,000 fewer REOs. The expected modification fee paid to lenders would total $250 million ($200/loan (my estimate1) x 1,250,000). The overall saving would be about $11 billion ((1,250,000 modified loans x $9,273 savings/borrower) – $250,000,000 in modification fees). At an average 17 year term, the estimated savings would be about $10 billion.

NOTES:

[1] For borrowers underwater by 20% or more, the fees would be near zero since this could be done as a unilateral modification with minimal paperwork.

“A shorter version of the above appeared in USA Today titled, “Opposing view: Don’t rely on refinancing.”

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