Christopher Papagianis

Recent changes to a mortgage refinancing program finally have it running smoothly and helping “underwater borrowers”: Can Congress really ignore this?

Fannie Mae and Freddie Mac’s Home Affordable Refinance Program (HARP) helps borrowers who are underwater (and only those who are current on their payments) refinance their mortgage at lower interest rates. While it took lenders a few months to implement the changes, hundreds of thousands of borrowers have already refinanced their mortgage or are in the pipeline to do so. The new HARP 2.0  includes a pricing regime that encourages borrowers to refinance into mortgages with shorter terms, which means borrowers are building back equity in their homes faster. And that is good.

Congress just broke for its August holiday, so we will have to wait until September for the next flare-up in housing policy. However, a debate was recently reignited that leaves plenty of room for thought.

Ed DeMarco, acting director of the Federal Housing Finance Agency, decided on the last day of July against allowing Fannie Mae and Freddie Mac to write down mortgage debt for underwater borrowers. This debate is several years old – and there is perhaps no other housing-related issue that has engendered as much partisan frustration.

Treasury Secretary Tim Geithner immediately sent a letter condemning DeMarco’s decision. But as Neil Barofsky (the former inspector general of TARP) noted in a recent column for Reuters, the simple fact that Secretary Geithner chose (merely) to send a letter demonstrates that what matters most in housing these days is, sadly, politics over policy. Barofsky continues: “Although one can argue whether principal reductions are the right way to address the ongoing housing slump … no one should be fooled that the administration’s entreaties to Mr. DeMarco are anything but political posturing.” Moreover, the entire effort “seems primarily intended to distract attention from [the administration’s] own failed policies.”

As the FHFA made clear in a recent report, there are approximately 4.6 million underwater borrowers with loans backed by Fannie Mae or Freddie Mac, but  “approximately 80 percent of [these] underwater borrowers are current on their loans.” Against this backdrop, the regulator estimates that only around 75,000 to 250,000 borrowers might be eligible for a write-down. Yet it would only take a few thousand “strategic defaulters” (i.e., those who previously were able and willing to pay but who decide to stop paying to qualify for the write-downs) for the program to result in taxpayer losses. Given the sheer size of the national mortgage market, DeMarco says a new principal reduction program “would not make a meaningful improvement in reducing foreclosures in a cost effective way for taxpayers.”

It is important to keep in mind that nobody – on the left or right – wants to “own” the risk that there could be even more taxpayer losses associated with the housing bust, or accept the political fallout from angry voters who believe policymakers are rewarding others’ bad decisions.

Nick Timiraos, a reporter for the Wall Street Journal, notes how the Federal Housing Administration (FHA) should be a prime “contender for the kind of principal forgiveness many would like to see Fannie and Freddie undertake,” since it would come without the hassle of having to work through an independent regulator. Unlike Fannie Mae and Freddie Mac, the FHA is a full instrument of the administration and subject to the congressional appropriations process. If the Obama administration is such a strong believer in the economics of principal forgiveness, why would it not pursue this policy at FHA, over which it possesses complete control?

Perhaps it’s because the FHA is on the brink of insolvency – and may very well require a congressional bailout. In fact, the Obama administration narrowly escaped having to announce a bailout earlier this year. This is unsurprising, considering the FHA has $2.6 billion in reserves against more than $1 trillion in total mortgage value insured (an effective leverage ratio more than 10 times greater than Lehman Brothers at the time of its collapse), and about 31 percent of its loans are underwater.

Taxpayers have lost more than $150 billion on bailing out Fannie Mae and Freddie Mac. Those are sunk costs. But a quirk in the government budget rules, coupled with a general inaction by the administration and Congress, has allowed the government sponsored enterprises (GSEs) to remain off budget and maintain an open line of credit from the Treasury to cover any future losses. As Timiraos notes, additional losses as a result of a principal forgiveness plan “may not be easily seen” at Fannie and Freddie, and certainly not in the context of a huge number like $150 billion.

The administration and Congress will probably take a pass on trying to overrule DeMarco on principal forgiveness. It’s just too dangerous for any politician to get linked to further taxpayer losses in and around housing before the election.

While more than 1 million loans were refinanced under HARP from 2009 to late 2011 – the HARP program had long been viewed as a disappointment (e.g., early promises by the administration had the program reaching millions more). But then FHFA decided to change the program’s underwriting criteria to try to responsibly boost borrower participation.

The new volume coming in under HARP 2.0 has been very impressive since it went into effect in March. This poses questions about whether the Senate should even consider a bill by Senators Barbara Boxer and Robert Menendez (aka HARP 3.0), particularly since changing HARP rules again would slow the nascent boom as lender systems are again changed. Here are the four key stats on HARP 2.0:

• In June 2012, HARP refinance volume was about 125,000, whereas in June 2011, it was only 28,000.
• In the second quarter of 2012, volume ran about 243,000, versus only 86,000 during the same quarter last year.
• In June 2012, borrowers with loan-to-value (LTV) ratios greater than 105 percent accounted for 62 percent of all HARP volume.
• June 2012 was the first month with meaningful refinance volume for mortgages with LTVs above 125 percent; over 53,000 refinancings were completed in the month, whereas March, April and May all fluctuated around 3,000.

The narrative behind these numbers is powerful. Even the objective underlying a new measure from Senator Jeff Merkley – “faster amortization,” or borrowers choosing shorter-term mortgages – is already ramping up. While only 10 percent of borrowers chose to refinance into shorter-term mortgages under HARP in 2011, in May the number was 19 percent and in June it was 18 percent. This hurts arguments for further legislative action as well, since a bill would come with a delay for implementation and unsettle the current process, which is working.

Senators Boxer and Menendez are the key champions of expanding the HARP program. (Note: I testified before the Senate Banking Committee on this bill back in May.) Senator Merkley’s measure would provide greater incentives under HARP (perhaps with a taxpayer cost) for borrowers who choose to refinance into shorter-term mortgages, so they end up paying down their balance faster and regain equity in their homes. In many ways, this effort is an alternative to principal forgiveness for underwater borrowers.

Acting Director DeMarco and FHFA deserve more credit than criticism these days. Examining the nuances of the principal forgiveness debate, especially in the context of the new HARP 2.0, provides a solid guide for where the policy discussion is headed this fall: nowhere fast. And that’s probably a good thing for taxpayers and struggling borrowers.

PHOTO: Homeowners Jesse Fernandez (R) and his brother Joel Fernandez (C) speak with a Freddie Mac representative as they try to get a home loan modification during the Neighborhood Assistance Corporation of America event in Phoenix, February 4, 2011. REUTERS/Joshua Lott

This post is adapted from the author’s testimony at a recent hearing before the U.S. Senate Banking, Housing, and Urban Affairs Committee.

Many of the major negative housing trends that dominated the headlines since the crisis are now well off their post-crisis peaks. While prices are only flat to slightly down year-over-year, there is finally some optimism for probably the first time in more than three years. But before we get ahead of ourselves, let’s examine some of the economic fundamentals and also assess the policy and regulatory headwinds that are still blowing from Washington.

New delinquencies are trending lower on a percentage basis. The decline in home prices also appears to be leveling off or approaching a bottom on a national basis. Data from CoreLogic suggests that house prices have increased, on average, across the country over the first three months of 2012 when excluding distressed sales. Even the numbers from the Case-Shiller Index out this week suggest that a floor in home prices has been reached.

There is also a relative decline in the supply of homes for sale. The chart below shows how the existing stock of homes for sale is now approaching a level equal to five to six months of sales. This is a very promising development. According to the Commerce Department, the housing inventory fell to just over five months of sales in the first quarter, the lowest level since the end of 2005.

In short, the level of housing supply today suggests that the market is close to equilibrium, which implies house prices should rise at a rate consistent with rents. Market analysts often look at a level above or below six months of sales as either favoring buyers or sellers, respectively. It’s not surprising then that the recent stabilization of home prices nationally has occurred as the existing inventory, or supply level, has declined.

A couple of important caveats should be kept in mind, however. First, almost any discussion of national inventory trends can gloss over regional problems, or acute supply challenges in individual state markets. Second, the transaction data around home sales suggests that any near-term demand-supply equilibrium is occurring off of an extremely low transaction volume. In essence, weak demand for single-family homes appears to have eclipsed the supply challenge moving forward for the housing market.

Consider that homes are more affordable than they have been in decades.

The National Association of Realtors Home Affordability Index measures the “affordability” of a median-income family purchasing a median-priced home (using a 20 percent downpayment for a 30-year fixed rate mortgage). All of which is to say that house prices look low on a historical, user-cost basis.

So, this begs the question: Why are home sales still so depressed?

One major reason: tight lending and underwriting standards. Earlier this month, Federal Reserve Chairman Ben Bernanke commented on this trend by reviewing information from the latest Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS).

Most banks indicated that their reluctance to accept mortgage applications from borrowers with less-than-perfect records is related to “putback risk”– the risk that a bank might be forced to buy back a defaulted loan if the underwriting or documentation was judged deficient in some way.

Federal Reserve Governor Elizabeth Duke also gave a speech earlier this month on this theme, providing yet even more detail on the conclusions from the April SLOOS:

• Compared with 2006, lenders are less likely to originate Government Sponsored Enterprise-backed loans when credit scores are below 620 regardless of whether the downpayment was 20 percent or not.
• Lenders reported a decline in credit availability for all risk-profile buckets except those with FICO scores over 720 and high downpayments.

When the lenders were asked why they were now less likely to offer these loans:

• More than 84 percent of respondents who said they would be less likely to originate a GSE-eligible mortgage cited the difficulty obtaining mortgage insurance as factor.
• More than 60 percent of lenders pointed to the risks of higher servicing costs associated with delinquent loans or that the GSEs might require them to repurchase loans (i.e., putback risk).

Another important market development to acknowledge is that lenders can’t keep up with demand, particularly with regard to mortgage refinancings. Anecdotal evidence suggests that some lenders are simply struggling to process all the loan applications coming their way. Part of the problem appears to be the structural shift in the market toward full and verified documentation of income and assets, which has lengthened the processing time for mortgage applications.

But if lenders and servicers don’t have enough capacity, why are they not just hiring more staff or upgrading their infrastructure so they can handle more loans or business? This seemingly innocent question is really important. Don’t market participants still perceive this business as profitable long term with a comparatively good return on investment when viewed against other business lines?

Governor Duke’s conclusion is spot-on. Lenders or servicers are hesitating in the near term because they just don’t have a good sense of how profitable the housing finance-and-servicing business will be over the medium-to-long term.

And that’s because of the policy questions that haunt the housing sector. There is perhaps no other major industry that faces more micro-policy uncertainty than housing today. Putting aside broader GSE reform, these uncertainties can be grouped into two buckets: servicing and underwriting.

On the servicing side, federal regulators are in the process of establishing new industrywide rules governing their behavior, changing how servicers get compensated and altering the way the business itself can be valued if it’s part of a broader bank balance sheet.

On the underwriting side, the Dodd-Frank law pushed regulators to try to finalize very complicated rules governing who should be able to qualify for certain types of mortgages (i.e., ability to pay standards), including those that are bundled into mortgage-backed securities.

All of these actions will affect the future of house prices, as credit terms and mortgage availability are intimately linked to the user-cost of housing generally.

The urgency to resolve all of this uncertainty is all the more important because while there are clear short-term impacts on the market, there are also potential long-term consequences. For example, if lenders decide to hold off on making new near-term investments in their mortgage business, the long-term potential of a full rebound in housing may be diminished as the existing or legacy infrastructure and skills can be expected to atrophy further.

Mortgage servicers are not in business to lose money. Moreover, the total volume of resources devoted to performing this function – employees, investment in computers and telecommunications infrastructure, legal compliance officers, sales staff – is not static. It adjusts upward and downward based on perceived opportunities, expected future revenues and government involvement.

Some big investments are not being made because of concerns that regulations will impose costs on the industry that cannot be recovered through servicing fees or other revenue streams. Here there have been a few positive developments recently, suggesting that at least some investors are willing or able to take on the aforementioned headwinds.

Non-bank and specialty mortgage servicers like Nationstar and Ocwen are buying up MSRs from the large banks. Home prices also appear to have reached the point where investors could buy properties and rehabilitate them for less than it would cost to construct them brand-new. This trend helped spark some fresh investments in late 2011, which has generated some modest momentum for 2012. In the first quarter this year, GDP was 2.2 percent and residential investment provided a 0.4 percent contribution or share of that figure.

But so much policy uncertainty still looms.

No one really knows who the ultimate purchasers of mortgages are likely to be five years from now. Since the ultimate holders of mortgages – currently Fannie Mae and Freddie Mac, on behalf of the government – are the servicers’ client base, the current lack of clarity on who or what is likely to fund mortgages in the future has obvious ripple effects on servicers and all other professions exposed to mortgage finance.

A similar phenomenon is casting a shadow over the mortgage insurance industry. The difficulties in obtaining mortgage insurance are constraining lenders from selling to Fannie and Freddie, even if they have found buyers and are willing to originate the loans. Several mortgage insurance companies have failed in recent years, others are no longer offering insurance on a forward-looking basis and are just managing their existing exposures.

Resolving even some of the uncertainty holds by far the greatest potential for responsibly helping the housing market moving forward. It’s just too bad that there is an election in November, since it means policymakers and regulators can be expected to dither out of fear of upsetting a particular interest group before votes are cast.