Letting homeowners refinance at historically low rates would conjure billions of dollars of relief without the approval of a do-nothing Congress. What's the downside?
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Last week's $26 billion deal between the government and banks accused of mortgage fraud was the most significant effort to hold financial firms accountable for malpractice in the housing bust. The feds plan on using most of the money as a life-raft for homeowners who are underwater, or owing more on their mortgage than the value of the house.
But the deal is insufficient to address the housing crisis, and the U.S. economy still needs massive mortgage refinancing to flush out the worst of our debt overhang.
Since August, rumors have been flying around Washington that the White House was this close to putting out a plan to massively expand mortgage refinancing through its government-sponsored enterprises, such as Fannie Mae. This plan would let more homeowners refinance at historically low rates. Like waving a magic stimulus wand, it would conjure billions of dollars of relief for homeowners without Congress' approval.
WINNERS AND LOSERS
Last year, the administration updated the Home Affordable Refinance Program, or HARP, to allow borrowers to take advantage of ultra-low interest rates by refinancing their Fannie and Freddie-backed mortgages. In the State of the Union, Obama laid out a plan that would allow underwater homeowners whose mortgages were not owned by Fannie Mae or Freddie Mac to refinance into loans backed by the Federal Housing Administration.
The White House plan looks unlikely to pass, as House Speaker John Boehner has strongly criticized it. But if the White House is able to pass its plan -- or convince the Federal Housing Finance Administration, which oversees Fannie and Freddie to massively expand its current refinancing programs -- it would be a huge boon for homeowners, at a loss for some investors. (The money has to come from somewhere, right?)
Any expansion of refinancing means a transfer of money away from investors so that homeowners' monthly mortgage payments go down and their ability to save or spend goes up. Refinancing leads to a loss split up between different types of mortgage investors, but the effect on investors' income is likely to diluted (I'll explain shortly), while the permanent reduction in mortgage payments for homeowners is like an immediate, permanent tax cut. Homeowners win, a lot. Investors lose, a little.
How would the plan stimulate? Simply, it would push dollars - hundreds of billions of dollars, potentially -- into the hands of people more likely to spend it. As Joe Gagnon, a former Fed economist, has pointed out, homeowners would likely spend more of their new income than investors would cut back due to their lost income.
DEALING WITH THE LOSSES
When a mortgage is bundled and securitized with other mortgages, the holder of that security benefits from the stream of mortgage payments. If that stream of money changes - e.g. if a homeowner refinances by taking out a new mortgage at the lower prevailing interest rate - the investor suffers.
In the president's plan, only those who have been current on their mortgages for the past six months will be eligible for refinancing. So, the investors who will be affected by refinancing are exactly those investors that are getting a steady stream of payments at interest rates higher than the ones prevailing for new mortgages.
Who are these losers? They are the holders of private (or non-agency) mortgage-backed security. Pension funds, retirement plans, and mutual funds would take a big hit because they own an outsized share the particular securities likely to be impacted by the president's plan. According to data compiled by the Securities Industry and Financial Markets Association SIFMA, the non-agency MBS market that would be targeted by the president's new plan is worth $1.3 trillion. Insurance companies and pension funds hold some 29%; the GSEs and Federal Home Loan Banks own 22%, and foreigners hold 18%. (Another loser on the list would be big banks, for whom the White House has proposed a fee to pay for the plan.)
Many advocates for refinancing want the government to stick with the loans that Fannie and Freddie already guarantee -- some 70% of the mortgages nationwide. HARP already helps underwater homeowners whose loans are owned by the GSEs, and it has successfully refinanced nearly 1 million mortgages. But the impact has still been way too small. Last June, more than three-quarters of homeowners with 30-year, fixed rated mortgages were still paying rates greater than 5% even though they could refinance at 4%.
Won't the loss of investment income to Fannie, Freddie, and the Fed mean some loss to the taxpayer? Maybe. But it won't affect the economy much right now. Two economists at the New York Fed have pointed out that prepayment on bonds held by the government will not affect the government's domestic spending right now. Additionally, the Fed intervened in the agency MBS market precisely in order to bring down mortgage rates and stimulate housing. Refinancing is one of the "channels" by which the Fed's low interest rate policies stimulate the economy and that channel has been blocked by hurdles in the refinancing process.
What about the rest of the market: the savings institutions, bank-holding companies, real estate trusts, pensions funds, and insurance companies who hold roughly half of agency MBS? In fact, these investors have benefited from a remarkable windfall. Homeowners who would normally be taking advantage of extremely low interest rates can't do so, because they've lost too much value on their homes to refinance. This suffering among homeowners has, morbidly, been good for investors. But it seems both morally questionable and economically inefficient to allow them to get away with this windfall forever while the economy muddles through a non-recovery.
Refinancing might sound like a dangerous bazooka to fix the housing crisis. In fact, it is, simply, a sound solution.