Last Wednesday, February 18th, President Obama presented his Homeowner Affordability and Stability Act. The elements of this plan are worth contemplating as well as questioning. The key components of the Affordability and Stability Act are: (1) Providing access to low-cost refinancing for responsible homeowners suffering from falling home prices, (2) Create a $75 billion homeowner stability initiative to reach 3-to-4 million at-risk homeowners, (3) Supporting low mortgage rates by strengthening confidence in Fannie Mae (FNM) and Freddie Mac (FRE).
The first component is referring to the historic low mortgage rates that are giving many folks the opportunity to refinance their mortgages to lower monthly payments. However, some owners are not able to refinance due to current rules that make it difficult for borrowers to refinance if they owe more than 80% of the value of their home. The second component, a $75 Billion homeowner stability initiative to prevent foreclosures and help responsible families stay in their homes, is a comprehensive plan made up by the Treasury working with the Government Sponsored Enterprises (GSEs), FHA, and the FDIC. The strategy includes the following six features:
- A homeowner stability initiative to reach up to 3 to 4 million at-risk homeowners
- Clear and consistent guidelines for loan modifications
- Requiring that financial stability plan recipients gain guidance for loan modifications
- Allowing judicial modifications of home mortgages during bankruptcy when a borrower has no other options
- Requiring strong oversight through reporting and quarterly meetings with the Treasury, FDIC, Federal Reserve and HUD to monitor performance
- Strengthening FHA programs and providing support for local communities
The third and final initiative deals with strengthening the GSEs by increasing their funding limits with funds already approved for this purpose in 2008. This will also provide forward looking hope for Fannie and Freddie. Let’s breakdown each section.
‘Access to low cost refinancing’
Since home prices have been falling it has grown harder for responsible homeowners to refinance at lower mortgage rates. Borrowers who took out conforming loans that were owned or guaranteed by either Fannie Mae or Freddie Mac will be able to refinance through the two institutions. The plan says that it will allow 4-to-5 million homeowners access to affordable refinancing. Aside from stating how many homeowners will be helped, this section only provides one example of how much a borrower can save if they are able to refinance to a lower rate.
The first concern is the fact that not every homeowner who is currently in foreclosure is a “responsible/honest/hard working individual.” Let me first say that there is enough blame to go around and that I am not in any way solely attacking the homeowner, as some in power are attacking only our financial institutions. On that note, who is going to determine whether a borrower is responsible or not? A Responsible Homeowner Qualifying Subcommittee made up of industry experts and Sen. Chris Dodd (who should know all about reworking mortgages since his was overhauled by Angelo Mozzillo).
However, there are many irresponsible borrowers that this plan will end up helping, contrary to its pledge. Why should I help keep other borrowers in their homes, while I am trying to save to purchase my own home in a year? Why do my parents have to cut back on spending for themselves just so they can help Joe and Kathy Smith stay in their home? This plan says it is aimed at keeping people in their homes and keeping the “American Dream” of owning a home alive, but this is only the start of the redistribution policies the administration was promising in their campaign. Besides, maybe not everyone needs to own a home.
3 - 4 Million Homeowners
One of the most important points of the initiative comes from the first feature of the second key. Lenders can bring down monthly payments through principal reduction. By reducing the principal on negative equity mortgages, borrowers have an incentive to continue making payments as opposed to walking away. For example, a home was purchased with an $80,000 mortgage when the value of the property was $100,000. Due to the current recession, the value of the home has decreased to under $80,000. Now the borrower owes more than the house is worth. People who may not be as knowledgeable about the consequences associated with defaulting will simply walk away from the house. Then again, who can blame them; they are paying more than what the asset is worth. The plan will provide a monthly balance reduction payment that goes straight towards reducing the principal balance on the mortgage loan. And as long as borrowers stay current with their payments they can receive a check for up to a $1,000 each year for five years just for paying on time (I bet my parents would love to have that offer). I thought that when you took on a debt you shouldn’t have to be paid or given an incentive to pay it back, but maybe I’m just old school.
A big problem with the obsessive lending was the relaxing of qualifying ratio limits and approving loans with very large back-end ratios. The back-end ratio is the total amount of all your monthly debt divided by your gross income. Safe and standard back end ratios used to be in the 30%-40% range. Many borrowers during the housing boom were getting mortgages with back-end ratios of 50%, 60% and even 70%. There was no way they were going to be able to make all their payments.
The plan states that borrowers with very high back-end ratios, 55% or higher, qualify on the condition that they go through HUD-certified consumer counseling. This counseling can have long term effects by providing the proper education to people about the risks associated with taking out a mortgage. The language in the plan gets fairly interesting now. “Bring down rates so that a borrower’s monthly mortgage payment is no greater than 38% of their income.” At first glance, this looks good. But this is not the back-end ratio, rather it is the front-end ratio. The front-end ratio is only the monthly mortgage payment divided by your monthly income. The current front-end ratio standard is 33%. So it is a good first step to reduce the front-end ratios to 38% with the intent of going down to 31%. However, the plan does not mention anything about the potential revised back-end ratio limits. If a borrower still has 10% or more in other debt payments, such as car payments or other loans, they may have a revised back-end ratio of 48% or higher. So, even after a borrower has refinanced to a lower rate and lower payment they may still not be able to afford it!
While reading through the plan I kept having moments of déjà vu. “Supporting Low Mortgage Rates by Strengthening Confidence in Fannie Mae and Freddie Mac.” Maybe I’m wrong, but weren’t these two “backbones” of the mortgage market part of the reason we got into this mess? These pseudo-private companies with implicit government backing forced lower rates and accepted lower standards from borrowers so more people could “live the American dream.” Now they are back at it, but with a different reason for the madness: saving the housing market. The plan states that it “will help 7-9 million families restructure or refinance their mortgages to avoid foreclosure.
Currently, a borrower cannot refinance a Fannie Mae loan if the loan-to-value ratio (LTV) at the time they want to refinance is greater than 80%. Therefore, the plan would allow borrowers to access the current low mortgage rates. The Treasury department is going to use approved funds to increase its funding commitment to Fannie and Freddie. They will also continue to purchase Fannie and Freddie mortgage-backed securities to “promote stability and liquidity in the marketplace.” Basically, the government is propping up the mortgage market as apposed to the invisible hand conducting the market; in the process, the government is increasing our nation’s debt load. Sometimes people forget that there is no such thing as a free lunch, and that the money to buy the mortgage backed securities has to come from somewhere. It will get pretty interesting when Japan and China stop buying our debt. Increasing the size of the mortgage portfolios at the GSEs by $50 billion to $900 billion is a scary prospect as well. We have already seen how well these two entities manage the assets on their books. The bad debt that they held previously and their mismanagement are the reasons their implicit guarantee by the government became explicit.
As long as the invisible hand is not allowed to work, and we continue to put our faith in the two GSEs , it is going to be hard for our housing market to make a proper turn around. A recovery obviously needs to occur, because it isn’t the auto industry that makes a nation strong, it is a properly functioning and robust housing market.
- Patrick Dougherty
Disclosure: Joe and Kathy Smith are not real people. Fannie Mae reported a $25.2 billion loss in 4Q ‘08. Their net worth is now negative.