Steroids for the Government's Housing Intervention?

There's a new rumor that the U.S. government might be cooking up a new plan to use the mortgage market to stimulate the ailing economy. The Financial Times writes this week that a new proposal is being whispered about in Washington. It would reportedly offer homeowners the ability to refinance at ultra low rates, even below the market. Could it really work -- and should this tactic be used by the government?

FT Reports:

The US Treasury is planning a conference this month to discuss the mortgage market, including reform of state-backed mortgage financiers Fannie Mae and Freddie Mac, which are now financing nearly all new mortgages.

"The mortgage summit planned later this month has begun to attract a lot of attention among mortgage investors and has led to growing speculation of a massive [refinancing] wave," said Steven Ricchiuto at Mizuho.

First, think about the current U.S. economy. With the home buyer credit gone, demand in the housing market has plummeted. Add onto that the fact that the HAMP foreclosure prevention program continues to struggle. Finally, consider the government's desire for more fiscal stimulus, but its inability to get a bill through the political process. Combine all those factors, and imagine potential a solution: ultra-low mortgage loans offered by the government-sponsored entities.

All those problems could, theoretically, be remedied by this plan. Perhaps rates would now be low enough to conjure up some housing market demand. Some at risk of foreclosure might be able to refinance their mortgages and more easily afford the payment. With other homeowners lowering their monthly payment through refinancing, they would have more cash to spend and heat up economic growth to encourage hiring.

Is it the perfect plan? Not based on past experience. It shows that all of those potential outcomes aren't likely. Record low mortgage rates have, thus far, failed to encourage more home buying. Why would rates a little lower help much? The issue with HAMP isn't interest rates, but loan principal exceeding the home's new value. That problem would persist, so strategic and involuntary defaulters would still feel that foreclosure is the best option for an underwater mortgage. Finally, if consumer sentiment remains low, Americans will just save extra money they get through refinancing, rather than spend it.

One significant problem with this plan is mentioned by FT. The rumor has slowed down the already weak market for mortgage bond investing. If a large volume of refinancing occurs, then these bonds would lose value. So investors are right to be worried.

Second, the proposal would result in a kind of a bizarre transfer payment from the poor to the wealthy. Homeowners would benefit, but all taxpayers would be on the hook for a bigger mortgage market exposure, which could ultimately result in losses and financing costs placed on the shoulders of all taxpayers. Thus, renters, who are generally less affluent than homeowners, would share in the cost, but not the direct benefits.

Moreover, if some gigantic percentage of current mortgage borrowers were to refinance all at once at rates that will probably never be seen again, this could cause all kinds of economic mayhem for years to come. Think of it like cash-for-clunkers, on steroids, for all mortgage borrowers. Due to the long-term nature of home loans, you would pull probably between 15 and 30 years of mortgage funding demand forward. We saw the sort of distortion that occurred when just several months of demand was pulled ahead. Now imagine a huge one-time refinancing tidal wave followed by a decade or two of virtually nonexistent mortgage financing.

This would make labor mobility even worse. If you lock in a 3% mortgage rate, you'll never want to move if it means stepping up to a 6% rate. If your monthly payment was $1,000, then you would have to move from a home worth $237,000 to one worth $166,800 to keep your payment level at the new mortgage interest rate.

Housing market turnover would also become incredibly low for a few decades. It would become far more common to pass on mortgages from one family member to another, rather than purchase a new home. The future of the housing market would be even bleaker than it appears right now.

With any luck, this rumor is just that -- a rumor. But as policymakers in Washington feel more and more desperate to have an impact, anything is possible. Let's just hope they have sense enough not to do anything so drastic.