Obama's Mortgage Refinancing Effort: This Time It's Different

Up to now, the administration hasn't had a very successful program to help homeowners. Will its latest attempt fare any better?

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A few years ago, the Obama administration unveiled an effort to refinance millions of mortgages owned or guaranteed by Fannie Mae and Freddie Mac. It didn't work out so well. After two-and-a-half years, the program accounts for less than a million mortgages refinanced. As a part of the White House effort to stimulate the weak economy, the president hopes to fix this program. Due to a couple of key changes, it may work better now.

What's New This Time?

So what's different now compared to 2009? Now the effort has more parties on board who have agreed to expand its reach. In particular, the Federal Housing Finance Agency, the regulator responsible for housing finance giants Fannie Mae and Freddie Mac, has agreed to loosen a number of requirements. Let's look at some of the key problems and solutions.

Problem: Underwater and slightly-above-water borrowers are not eligible.
Solution: Provide refinancing regardless of equity levels

This is arguably most significant change. For borrowers whose mortgage is owned or guaranteed by Fannie and Freddie, the FHFA will ignore how much (or how little) equity they have in their home when they apply for refinancing. So even if a family's mortgage balance is much larger than the value of its home, it could still qualify for refinancing if other conditions are met. This is a big deal. In the past, borrowers' loans could not exceed 80% of the value of their home, at most.

In a period after home prices fell dramatically, this criterion severely limited the population who could refinance. Now millions of underwater or slightly above water Americans may be eligible for refinancing. This applies to borrowers who have fixed-rate mortgages. An loan-to-value ceiling of 105% still applies to borrowers with adjustable-rate mortgages.

Problem: Refinancing fees are too expensive for some borrowers.
Solution: Eliminate or reduce fees significantly

Fannie and Freddie ("F&F")have agreed to eliminate certain risk-based fees for borrowers who refinance into shorter-term mortgages (like a 20-year mortgage instead of a 30-year). For other borrowers, the fees will be reduced. With the big front-end cost of refinancing reduced, borrowers will be able to more easily afford it.

Problem: Appraisals add delays and additional costs. 
Solution: Allow process to rely on "automated valuation model" appraisals when available

Currently, F&F use an automated valuation model to estimate property values. Now it will rely on this method for all refinancing through this program, instead of bothering with 3rd party appraisals. This will cut costs for refinancing and make the process less cumbersome. Since the value of the home relative to the loan size isn't contingent on refinancing anymore anyway, obtaining one or more carefully performed appraisals isn't necessary.

Problem: Mortgages sold to F&F are subject to representations and warranties that make banks nervous about refinancing. 
Solution: Waive those reps and warrants

In this case, lenders are being provided cover for refinancing. When lenders provide a mortgage, they make certain reps and warrants to F&F about the quality of the loan. If the mortgage is refinanced, the lender could retain some liability due to the quality of the loan. F&F has decided to waive certain reps and warranties if lenders commit to refinancing. This would help to protect lenders if these refinanced loans eventually go bad.

Problem: Second liens in place complicate refinancing the first mortgage.
Solution: Automatically re-subordinate second liens after refinancing

This one is a little complicated but very important. Many homeowners have second liens on their mortgage, like from a home equity loan. When a refinancing occurs, the old mortgage contract is wiped out and a new one is created. But if a second lien is in place, then it should take place ahead of that new mortgage. Since no lender wants their new mortgage to have only second priority, they might not want to allow a new refinancing. FHFA says that "all of the major lenders" have agreed to automatically re-subordinate their second liens after refinancing under the Treasury's program.

Problem: Providing millions of refinancing actions is hard to do in a short period of time
Solution: Extend the timeline of the program out very far

This program officially begins on November 15th and will be in effect through the end of 2013. Two years should be plenty of time for eligible borrowers to take advantage.

Why These Changes Matter

The administration appears to have accounted for all of the major obstacles to refinancing and eliminated them. A home's value no longer matters. The cost should be less prohibitive to borrowers. Much legal red tape has been cut. Other loans tied to the home won't stand in the way. Ample time to refinance is provided. This should help to allow at least a million Americans to refinance who haven't had the opportunity to do so in the past.

If this works as hoped, then those consumers will have more money in their pockets each month. Borrowers who see their mortgage interest rates drop from 5% or 6% to near 4% will often have a few hundred dollars more per month to spend or save. If they spend that money, then it will stimulate the economy and create jobs. If they save it or pay down their current debt, then their personal balance sheets will be healthier sooner and their spending will rise sooner than it would have otherwise. The effort may even prevent some strategic defaults, as underwater borrowers won't feel as bad about their mortgages if their payment is reduced significantly.

But as always, we should hold our applause here to see how the program actually fares once it's put in place. The administration offers no estimate of how many borrowers this will help. It's hard to blame them: in the past they have created programs claiming to help millions of homeowners and came up embarrassingly short. The Treasury may have failed to anticipate some obstacles, but this program does appear to have most potential pitfalls covered.

The Puzzling Parts

Although this program looks like it will work as advertised, a number of questions remain unanswered.

Why FHFA's Change of Heart?

In theory, the FHFA could have agreed to these significant changes two years ago. Why are they coming around now? The official answer is that the FHFA realized that the housing market will recover faster if underwater borrowers have lower payments. That may be true, but then it would have been true two years ago too. What changed?

Won't Help Anyone Facing Foreclosure

This program only applies to fairly pristine borrowers. To qualify, a borrower needs to have been current for the past six months and to have missed no more than one payment in the past year. Put another way, families struggling to pay their mortgage and facing foreclosure need not apply. Although the program may do wonders to help reduce the interest rates of borrowers who can afford to pay their bills, it won't help those in trouble.

Why Stop Here?

This program only applies to loans owned or guaranteed by F&F. The FHFA says that it has no control over other mortgages. This isn't entirely true, however. It could easily relax its mortgage acquisition criteria in a similar fashion to allow lenders to refinance any loan.

For example, let's say that a mortgage is owned by some investor, where the borrower is underwater. Fannie could agree to buy or guarantee that loan once it has been refinanced. It can also agree to waive the lender's reps and warranties. These changes should make many lenders jump to refinance. It would also increase the size of F&F's portfolio. But if they're really committed to getting as many Americans refinanced as possible, then why not allow their portfolio to grow?

How Did F&F Make Peace With the Risks?

Let's hypothesize about why F&F were nervous about refinancing these mortgages in the past. I can see two big potential risks with the plan.

First, they may have been scared about underwater loans defaulting: if interest payments leading up to default were smaller due to refinancing, then the companies would have been provided less revenue to compensate for the loss they'd be hit with.

Second, they may have been worried about the interest rate risk. Interest rates are at historical lows. When they eventually rise, F&F's financing costs will rise significantly, but its mortgage payment cash flows will be locked in, based on very low fixed interest rates. That could be a recipe for disaster.

These risks still persist.

Why Is Treasury Letting F&F Incentivize Shorter-Term Mortgages?

Most borrowers will likely prefer to obtain another 30-year mortgage when refinancing. But F&F intend to provide an incentive for borrowers who shorten their term: they will entirely eliminate certain risk-based fees in this case. This makes sense from F&F's standpoint, since it helps to limit their interest rate risk.

But when a borrower lowers the term of their mortgage, their payment amount rises. If a borrower switches from a 30-year to a 20-year mortgage at a lower interest rate, their payment might not decline much -- if at all. While this is still good for the borrower, it isn't good for the Obama administration. They are pushing this program in large part to stimulate the economy. If the new mortgage payment is similar to the old one, then that borrower won't have extra money to spend on other stuff. Instances of refinancing where payments remain unchanged would have no direct means of stimulating the economy.

So we'll see how this program does. If it is moderately effective, then it could result in lots of money injected into the economy by consumers who refinance. Ultimately, however, taxpayers will bear the cost. Much of the additional interest these borrowers would have paid won't be going to Fannie and Freddie. Since the government bailed out and now owns the companies, either they won't be able to pay back taxpayers as quickly (or at all) or they will have bigger losses in future quarters (and will require bigger a bigger taxpayer rescue). So like all other stimulus, this one has a distinctive buy now, pay later flavor. But if it boosts consumer confidence and spending to encourage hiring, maybe it will turn out to be worth the cost.

Image Credit: Sam Beebe/Ecotrust/flickr