THE BASIS POINT

Goldman Sachs Q&A On Senate Housing Bill

Below is a Q&A on the Senate Housing Bill from the economic research team at Goldman Sachs.

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Key Senators reached agreement on housing legislation yesterday and passed their bill in committee today. This legislation has now cleared its highest hurdle, and looks increasingly likely to become law.

Differences exist between the House and Senate versions of the bill, and some key issues remain that could reduce the effectiveness of the proposal. Nevertheless, the legislation looks likely to reduce foreclosures by slightly less than 10%. While positive, the bill could have somewhat negative implications for the jumbo mortgage market, as currently conceived.

Housing-focused legislation now looks more likely to become law than it did just two weeks ago when such initiatives appeared to be losing momentum. Senate Banking Committee Chairman Chris Dodd (D-CT) and Ranking Member Richard Shelby (R-AL) announced last night that a compromise had been reached on housing legislation and passed the bill today in the Senate Banking Committee. We had expected continued progress on these initiatives, despite the recent perception that intervention proposals had lost momentum. [1][1] In what follows, we respond to some of the most frequently asked questions on the bill and the politics surrounding it:

Q. What are the differences between Senate bill and what the House passed two weeks ago?
A: The bills are mostly the same. Both include a proposal to refinance underwater mortgages through the Federal Housing Administration (FHA) and both include legislation to increase regulatory oversight of the housing-related government sponsored enterprises (GSEs): Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. (See the report referenced above for details of the House bill). While there are numerous small differences, only a few significant differences exist which will need to be reconciled:

1. Loan limits would remain elevated but would decrease from current levels. Economic stimulus legislation enacted in February increased the limit on loans that Fannie Mae, Freddie Mac and the FHA may purchase or insure to as much as $730k in some high cost areas, from the previous limit of $417k nationally. While the House legislation would make this arrangement permanent, the Senate bill would lower this limit to $550k. More importantly, it would only allow these loans to be securitized, rather than purchased for the GSEs’ loan portfolios. Both of these changes could have somewhat negative implications for higher priced areas; in the last several weeks, the GSEs have begun to price this new segment of “jumbo-conforming” loans roughly flat with traditional conforming loans (i.e. those below $417k), eliminating the 100 to 150bps spread that has existed since the limits were raised. They are able to do this under the assumption that they can hold these loans in their portfolios. Securitizing these loans is likely to be less effective, and a requirement to do so could result in a jump in rates in this segment of mortgages.

For a more in-depth discussion of the House bill, see the US Economics Analyst (08/19) Mortgage Proposals: Most Agreement Than Meets the Eye, May 9, 2008.

2. The FHA refinancing program would be funded by the GSEs rather than the taxpayers. The House-passed FHA program was estimated to cost up to $1.7bn, and we saw the risk to be to the upside of that estimate.[2][2] The House proposal would have simply added that cost to the deficit. To pay for the cost of this plan, the Senate proposal would levy a fee on the GSEs equal to 4.2bps of the unpaid balance of new mortgages purchased or securitized. This is likely to result in a few hundred million dollars per year in fees paid by the GSEs, depending on how many loans the companies purchase. Over the next four years, the portion of the fund directed to the FHA program would decrease, and the portion allocated to affordable housing would increase, so that by 2012 the entire fund would be dedicated to affordable housing programs, as was intended when the fund was originally proposed last year (that proposal was never enacted).

3. The FHA refinancing program is estimated to cost less. The program under the Senate proposal would incur a net cost of $500 million, according to the bill’s sponsors, rather than the $1.7 billion estimated under the House proposal. Part of this difference appears to be due to limiting the operation of the program to three years. The official cost estimate has not been released, however.

Q: Will the bill put a “floor” on home prices?
A: The legislation could have an incrementally positive impact on home prices, with the emphasis on incremental. In order to reduce the decline in home prices meaningfully the bill would need to do two things: first, decrease excess inventory or at least prevent inventory from building, and second, provide an incentive for first time homebuyers to enter the market sooner rather than later. The House bill did both of these things on a very small scale. The Senate version that passed today only deals with foreclosures, but tax provisions may be added in negotiations with the House.

The Congressional Budget Office estimates the House bill would result in the refinancing of 500,000 loans, of which 175,000 would still likely default. If the current foreclosure start rate of 3.3% continues, repossessions would add nearly two million units to the supply of homes on the market this year and a similar amount in 2009. If the legislation results in the refinancing of as many loans as CBO predicts, and all of these loans would ended in foreclosure and resale (an aggressive assumption), this intervention would reduce the additional excess inventory coming onto the market by nearly 10%, assuming that most of the refinancing activity is spread over 2008 and 2009.

Q: Have they cleared up the securitization and second lien-related issues?
A: Not really. The likelihood that servicers will agree to write down principal on loans in order to participate in this program depends on 1) the perceived likelihood that a borrower defaults, 2) the expectation that a given home’s value declines substantially further from current levels, and 3) the presence or absence of second liens on the home. The first two questions are largely up to the servicer. However, the House and Senate bills attempt to provide servicers with legal protection from bondholders when they make such modifications. On the question of second mortgages, both bills allow the FHA to facilitate agreement between senior and subordinate lien holders, but neither forces second lien holders to accept any particular terms nor do they make any specific arrangements to pay the holder of the second lien holder to induce them to accept the terms of the refinancing. This could potentially block the participation of nearly half of subprime loans originated in the last two years since they have second liens attached.

Q: What are the next legislative steps?
A: The legislation is likely to go to the Senate floor in early June. We expect the bill to pass easily, given the near unanimous 19-2 vote today in the committee. Further changes to the substance of the bill are likely on the Senate floor, but we expect the bill to emerge from that process mostly as it stands today. From there, the House and Senate must work out differences between their respective versions. The two most important issues that House and Senate negotiators must agree on relate to the use of the proposed affordable housing fund and the restrictions on jumbo-conforming loans. On both questions, whatever emerges from the Senate floor in a few weeks seem more likely to prevail in the final version.

Finally, the president must sign the bill into law. The Bush Administration has not officially endorsed the Senate approach, but appears to be taking a more constructive stance in reaction to the estimated reduced cost to taxpayers compared with the House version, and the inclusion of fairly strong GSE regulatory reforms. The White House is likely to take an official position on the bill soon, and certainly no later than when the bill reaches the Senate floor.

Q: When will all of this take effect?
A: Implementation of the FHA program does not appear likely before September or October of 2008. However, the loan limit changes and some other regulatory provisions in the Senate version would take effect immediately.

Q: Is that it for housing legislation?
A: Yes, at least until after the election. It is very unlikely that any proposals that do not make it into the final version of this legislation will be enacted into law this year. Among other proposals, this means the bankruptcy “cram-down” of mortgage principal, the tax loss carryback for corporations, and predatory lending restrictions and related regulatory reforms have probably been shelved until next year at the earliest. Clearly, some of these proposals will reemerge following the election in 2009, but the outcome at that point will depend largely on the results of the election.