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HARP, Refis Cannot Cure Negative Equity

Forget refinancing. A new hypothesis suggests targeted modifications would be much more effective in easing the negative equity crisis.

Government-backed or not, broad-scale refinancing is a weak stimulus that does not have the power to cure the negative equity pit ailing millions of underwater borrowers, said housing analyst Edward Pinto during his keynote presentation at the National Mortgage News Best Practices in Loss Mitigation Conference in Dallas.

Instead, the American Enterprise Institute resident fellow—known for his harsh views on government intervention in housing—proposes targeted modifications of GSE loans for severely underwater borrowers who are current.

According to Pinto’s calculations, such measures can reduce Fannie Mae and Freddie Mac’s taxpayer losses by about $10 billion.

So far, “given the underwhelming impact” of the taxpayer-funded stimulus, he said, refinances have become the stimulus of choice even though it is not free because “every dollar going to a borrower is taken from a saver.”

In a nutshell he argues that all refinancing, both the Home Affordable Refinancing Program and refinancing made possible by the low interest rate environment, are not an effective stimulus to improve the economic situation because they are not job-creation vehicles.

“HARP and refinances generally are a weak stimulus because for every dollar saved by a borrower, a dollar is lost by an investor,” Pinto told this publication. “As a result they are not particularly effective in creating additional demand that results in more jobs.”

At the same time the vast majority of HARP loans have a 30-year term, he said. “Therefore they do not address a big problem facing the real estate market—borrowers who are underwater on their loans.” These underwater borrowers “will remain under water for many years.”

“The Federal Reserve continues its efforts to lower interest rates and the administration keeps expanding mortgage refinance programs in an effort to promote more lending,” Pinto said. Pinto estimates that administration efforts to keep rates low have resulted in 14 million residential refis since 2009. Nonetheless the economic recovery “has been the slowest since at least World War II.”

His “modest proposal” targets severely underwater, nondelinquent GSE loans with a combined loan-to-value ratio of 120% or higher.

Such a program, which consists of a constant payment alternative, would apply to loans guaranteed by Fannie and Freddie before they went into conservatorship in September 2008.

The goal would be to retain the same monthly payments these borrowers have been paying for an average of five years and modifying the interest rate on the loan down from an average of 6.1% to today’s low rates of roughly 3.5%. He also suggests loan terms of anywhere from 15 to 17 years.

“This approach is very targeted and much more simple to execute,” he said. It will accomplish “the goal of rapid deleverage as the loan would now pay off in 15 to 18 years, and present little or no moral hazard.”

Pinto sees an advantage to dealing with underwater but current mortgagors because they have shown a consistent behavior to pay and are less likely to default on purpose.

But there is a catch for the GSEs. “Have Fannie and Freddie buy the to-be-modified loans out of the mortgage backed securities’ pools at par,” he said, which will make the intervention fair to the bondholders. His rationale: “These withdrawn loans are in the MBS that benefited from the direct taxpayer bailout of Fannie and Freddie, a bailout that was not legally required.”

He said there is a legal maxim here that reads: “Those that seek equity must do equity.”

Pinto’s equity math follows a basic example. An existing 6% interest rate on a 30-year loan originated in January 2007 with a monthly principal and interest payment of $839 for an original balance of $140,000 and a current balance of $130,000 and a current home value of $100,000 results in a 130% current LTV. (He also assumes there is zero nominal house price change.)

Currently there are two alternatives available.

If nothing is done in five years the LTV would be 117%. If the loan is refinanced through a typical HARP transaction into a 4%, 30-year loan with a $132,000 balance after paying $2,000 in financed fees, the monthly principal and interest payment would be $630 a month and after five years the LTV would be 119%.

Pinto’s constant payment alternative would allow “for borrowers substantially underwater” to modify their loan into a 3.375% interest, 17-year loan with a $130,000 balance and a $838 monthly principal and interest payment that after five years would have an LTV of 99%. Plus, they may only pay near zero fees when they modify their loan.

Another factor that in Pinto’s view needs to be taken into consideration is probability of default.

Quoting findings from “The Case for Accelerated Amortization,” a recent research study by Alan Boyce, Glenn Hubbard, Christopher Mayer and James Witkin, Pinto argued that the efficiency of this approach is evident given the fact that severely underwater GSE loans “have a high probability of default.”

It found GSE loans with LTVs of 125% or higher have an expected default rate of 15.78%.

The study also shows 26% of GSE loans with LTVs higher than 125% that were current as of December 2011, were 30 days or more delinquent as of March 2012—compared to only 11% of loans with LTVs of 100% to 109.99%.

“The taxpayer benefits are substantial,” Pinto concluded.

Using data from the aforementioned study, he quantifies these benefits at roughly $10 billion for average 17-year term modifications and about $11 billion for 15-year modifications.