Will Government Help With Underwater Homes (part 2)

In general markets trade off of future prospects and the prospects of a huge government-sponsored refi plan is roiling the markets. Any plan must help a broad group of homeowners, stimulate the economy, and cost next-to-nothing. Below is a continuation of yesterday’s post, and I also did some more analysis for mortgage banking consultants Stratmor Group, which you can read here.

One trader mentioned that

after HAMP and HARP the U.S. is now ready to launch a new program called Helping Underwater Mortgage Performance” and that the market “went toxic after it heard that Obama was getting “REFI.GOV” vanity plates for his new limo.

As one would expect, the prices of premium/older production are suffering compared to current/rate-sheet production. Yesterday, for example, Fannie 6’s (containing 6.25-6.625% 30-yr mortgages) were down .5 in price versus Fannie 4’s which improved nearly .250.

One proposal would allow millions of homeowners with government-backed mortgages to refinance them at today’s lower interest rates, which in turn would lower their mortgage bills and, in theory, help the economy since they’ll take the money and spend it elsewhere. Homeowners who have been unable to refinance their loans either because they owe more than their houses are now worth or because of bad credit. Other suggestions include a large-scale home rental program that would keep foreclosures off the market. What is lacking, of course, are any concrete details about any of this. Items such as how delinquent borrowers would be treated versus on-time borrowers, who would administer the program, and how would investors be made whole are immense issues.

In the meanwhile teams of researchers at all the investment banks are sending out educated guesses as to the pros and cons of various plans. (I bet this is what they really live for!) How are reps and warrants for existing loans handled? What about non-government loan borrowers? If borrowers who have their loans modified, or refinanced, stop making their payments, can investors go back to originators under buy back provisions? When did HARP become a verb? (“If you HARP these seasoned loans you are exposed to new put-back risk. If these borrowers default in their current form, it is very difficult for the agencies to put them back given servicers can argue the loans have been paying for 3+ years and therefore were issued as clean loans. However, once its HARPed that argument is no longer applicable and they are exposed to new put-back risk.”) And with Republican control, what are the odds of anything like this happening?

It seems that conjecture is focusing on basic plans. One is to make a low mortgage rate available to all borrowers. Another is a blanket settlement between originators and FHFA that settles all existing and future reps and warranties liabilities, and the originators will just be agents for the GSEs and will not be responsible for the credit performance of HARP refied loans. Another option is an expansion of HARP which will remove the origination date restriction for HARP eligible loans, thus allowing borrowers to do HARP multiple times and will make recent production HARP eligible. And the last seems to be implementing parts or all of the changes in Senator Boxer’s bill.

An analyst wrote:

I’m not sure I understand the economics/logic of a streamline refinance program. Assume for the moment that borrowers with high LTV’s, i.e., LTV’s >100%, a result of home price decline, could do a rate and term refinance from say 6% to 4.25%. Assuming an average remaining term of 25 years, the monthly P&I payment would drop by 16%. So, in real economic terms, how worse off is FNMA or Freddie? Before the rate/payment drop, the lender/investor has a loan on the books that is underwater and at high risk of default. After the drop, while the loan is underwater by the same amount, cash flow has dropped but the probability of default has arguably declined. Now I know that studies show that negative equity is the key driver of default, but I would argue that although the borrower’s equity position has not change the borrower’s perception of the situation has. Once a borrower is in a deep negative equity position, they probably view their monthly payments (after tax) as rent, not as payments on an investment. So, a drop in monthly payments is like a drop in rent which improves their likelihood of continuing the lease. Does the reduced likelihood of default compensate for the reduced cash flow? I haven’t analyzed this but I bet it’s significant and for some borrowers actually increases the economic value of the loan. And, the same argument would apply to loans in securities.