We must accelerate deleveraging of the U.S. consumer in order to improve not only the U.S. mortgage and housing markets, but also to aid the broader U.S. and global economies. Deleveraging will increase consumer confidence, net worth, job mobility and bank capital levels. But policymakers and economists are fairly ignorant of the mortgage market, which comprises by far the largest part of household credit.
So rather than curing the disease of excess household debt directly, they have instead treated the symptoms through government spending, tax cuts and monetary expansion. The benefits of these policies have been marginal and short lived. Now believing that the situation is hopeless, policymakers are ready to consign deleveraging to the slow attrition of defaults and amortization schedules. But the current interest rate environment offers an historic opportunity to both restructure debt and reform the mortgage market.
The risk-free interest rate is less than 25 bps for maturities under a year, yet households have received little benefit since they prefer the stability of long duration fixed-rate mortgages. What policymakers and consumers don't know is that ARMs have a lifetime interest rate cap, and this cap can be set to approximate the market note rate of the 30-year fixed mortgage at the time of origination. If an ARM is indexed to a short rate (one to three months) and has such a rate cap, then the borrower benefits from low interest rates in a steep yield curve, but even if future rates increase they are never worse off than if they got a fixed-rate mortgage to begin with.
With this general design in mind, separate programs can be created to benefit delinquent borrowers, negative equity borrowers and future mortgage borrowers.
The first program would be for Fannie and Freddie to offer modifications to a 1% ARM on all of their seriously delinquent, owner-occupied borrowers. A 1% rate sounds absurdly low, but it offers 25 bps of investor yield (minimum) from the interest rate index, plus 50 bps in credit guarantee fee, plus the standard 25 bps for servicing. No principal would be forgiven, though delinquent interest would be waived. That means the GSEs are getting 75 bps in cash flow on the full debt amount, plus principal payments (which amortize earlier on a 1% rate) versus their current cash flow of zero on loans that have been written down to a fraction of their face. In fact the 50 bps of guarantee fee would often be higher than the GSEs' current contractual fee on the delinquent loans.
The reduction to a 1% rate would usually lower the monthly P&I payment by 40% or more. In order to avoid the documentation fiascos of HAMP, the borrower would only need to document occupancy and not income, assets, or house value. If the borrower doesn't go for a virtually automatic 40% payment reduction, then that is documented as proof to the foreclosure judge that the borrower is not acting in good faith and the foreclosure is accelerated. This reduced documentation modification would be a one time offer, meant to clean the backlog of millions of delinquent mortgages. Although offering the mod without verifying income may seem unfair, even less fair is continuing on our path of millions of borrowers living in their house for years without making payments, all the while contributing to the decline in their neighbors' house values.
The second program would target the millions of overlooked borrowers who have negative equity but continue to make their payments. These borrowers would be offered refinances into a 1% ARM similar to that of the delinquent borrowers, but with a 20-year amortization term. The combination of a 1% rate and a 20-year term would significantly increase the scheduled payment's contribution to principal, even though the total monthly payment would drop by an average of 15%. The borrower would regain equity sooner by paying down their principal, which is certainly preferable to government coerced debt forgiveness. Subordinate liens would be included in the refinance. Because borrowers can watch their equity accumulate, and because their mortgage terms are such a good deal, they have incentives to stay current on the refinanced note.
Fannie and Freddie would purchase the 1% ARMs and package them into special MBS for sale only to the Federal Reserve. The special MBS would not bear the full guarantee of the GSEs, mortgage insurance would not be required, and there would be no cap on the eligible LTV. The Fed would bear the catastrophic credit and interest rate risk on the loans without compensation. As the Fed bought these negative equity MBS, they would sell an equal amount from their $2.6 trillion portfolio of U.S. Treasuries and agency MBS. In this way the Fed would supply safe securities that the market desires and absorb riskier assets that the market shuns, yet not expand the monetary base or money supply. The refinancing of high-risk subordinate liens would be a huge relief to the capital and reserves currently required on banks' second-lien and HELOC portfolios.
The third program would offer ARM products with standardized terms that better protect the borrower, while at the same time reducing the rapidly expanding interest rate risk borne by banks. Fannie, Freddie and FHA would offer ARMs indexed to short interest rates, but with lifetime interest rate caps set near the fixed rate alternative. The rates on these mortgages would be determined by MBS investor demand and without subsidy, so the interest rate would be higher than 1%, but still below current hybrid ARM rates. In order to eliminate payment shock, an ARM product will be offered with the payment fixed at the equivalent of a 30-year fixed payment amount, but with principal contribution that floats inversely to the variable interest rate. This is like an option ARM that is turned on its head to amortize even faster when rates are low, but never allows interest only or negative amortization payments. With the addition of this third program there is something beneficial for all consumers, which will lessen the public resentment that would occur if only the delinquent and negative equity borrowers were getting a good deal.
Notice that none of these programs call for principal forgiveness, new regulations, or additional government spending, although the Fed would subsidize consumers rather than continuing to make huge profits on their securities portfolio. Borrowers would bear some interest rate risk, which can be additionally mitigated by the choice of the index and initial fixed periods where needed. However, interest rates are unlikely to increase as long as the economy remains moribund—particularly when peripheral Europe defaults, China enters a recession and commodity speculation collapses. As observed in Japan for the last 20 years, deleveraging lowers risk free interest rates because the demand for credit falls as the supply of savings increases.
Many details of these three programs can be debated. But implementation starts with the recognition by policy makers that we can do something to improve the debt burden of consumers, thereby improving both the mortgage market and the entire economy.
Kent Willard is principal at MTG Risk, Winston-Salem, N.C.
