Cutting Through the Red Tape

The concept of utilizing a large scale refinance program to aid the ailing housing market and to stimulate the economy has been floating around since 2008 (1). Since then, rates eased below 4.0%, yet millions of Americans have not taken advantage of the opportunity because of the upfront costs of refinancing and other frictions unique to the current market. On May 8th, Senator Robert Menendez (D-NJ) and Senator Barbara Boxer (D-CA) proposed a bill that would attempt to deal with these issues.

The proposal by Senators Boxer and Menendez follows several of the recommendations made by President Obama earlier this year and includes:

• Extending streamline refinancing for Fannie and Freddie borrowers
• Elimination of up-front fees on refinances
• Eliminating appraisal costs for all borrowers
• Allowing lenders not currently servicing a loan to refinance the loan with the same representations and warranties and streamline ability as the current servicer, thereby creating competition and lower costs to the consumer
• Requiring second lien holders who unreasonably block a refinance to pay “restitution to taxpayers”
• Requiring mortgage insurers who unreasonably fail to transfer coverage to refinanced loans “to pay restitution to taxpayers”

To analyze the impact of the proposal, data generated by Lender Processing Services (2) was used to estimate the universe of mortgages held by Fannie Mae and Freddie Mac that are both eligible and likely to refinance under such a program. An average 30-year fixed rate mortgage of 4.0% along with a Federal tax rate of 25%, a state tax rate of 5%, and an average loan balance of $150,000 (3) were used to estimate the effect of the refinance program in the first year. It is assumed that borrowers with a current mortgage rate of 5% or higher will refinance (4) and there is no change in mortgage insurance premiums. The proposed changes would result in:

• Just over 3 million refinances
• Reduce the average annual payment by roughly $2,800
• Save borrowers $4.5 billion to $4.8 billion per year (after tax considerations) and more than $45 to $48 billion by 2022
• Some of the reduction in payments might result in increased savings, but much would be spent on goods and services (5). The lower payments would have a multiplier effect resulting in an injection to the economy of possibly the full amount of the money saved by borrowers or perhaps more.

The impact of a refinance program would extend beyond the savings to the consumer. The CBO (6) estimated that a similar program extended to loans securitized by the GSEs and FHA might result in 111,000 fewer defaults. Given the significant proportion of likely GSE refinances, the large number of loans held in portfolio that were not included in the CBO analysis, and lower subsequent CBO forecast for Treasury rates (and thus mortgage rates), it is reasonable to assume that the number of foreclosures averted by the GSE refinance plan would be substantial.

While the number of REO sales, modifications, and short sales have risen in recent quarters, the number of loans in foreclosure or REO remains high, thus underlining the need to staunch the flow of properties into this bucket. REOs are a significant problem for home sellers, the market and local communities:

• NAR estimates a price discount of 20% on REOs relative to non-distressed properties and some groups estimate this to be as high as 30%
• By one estimate, the sales price of a home was lowered by approximately 2.5% for every percentage increase in foreclosures in the same census tract, other factors constant.
• Homes that are vacant for an extended period impose costs on municipal governments ranging between $5,000 and $35,000, depending on length of vacancy, maintenance requirements, and damage to the home.
• Another study found a one percent increase in county foreclosure rate, increased the burglary rate by 10.1 percent. The impact was also significant on larceny and aggregated assault.

Finally, resurgent concerns about European financial conditions as well as the impending fiscal cliff in the Unites States will weigh on the 10-year Treasury and mortgage rates in the near term, allowing more time for consumers to take advantage of a refinance program.

While the estimated $4.5 to $4.8 billion in savings and reduced defaults may seem like small figures, these refinances could have a significant impact in the local areas where the refinances would be concentrated. Furthermore, the relaxation of representations and warrants and loan level pricing adjustments sets an important precedent that could help to ameliorate the tight lending conditions on the originations side of the market.

*********************************************************

1. See Hubbard and Mayer (2008) and Greenwald (2010)
2. Lender Processing Services, Mortgage Monitor; February 2012 Mortgage Performance Observations
3. Based on 4th quarter 2011 10k filing from Fannie Mae and Freddie Mac
4. Relaxing this assumption to a minimum reduction in monthly payment of 5% like the FHA’s streamline program would enable 560,000 additional refinances with a savings of $423 million in monthly payments.
5. Canner, Passmore, and Dynan (2002) assume that 100% of the reduced payment is devoted to personal consumption expenditures and McConnel, Peach and Al-Haschimi (2003) point out that households who refinance tend to have higher propensities to consume due to income constraint.
6. Remy, Luca, and Moore (2011), “An Evaluation of Large-Scale Mortgage Refinancing Programs”.