Economic Rx: More Refinancing

Original Post Date: September 6, 2011

By: Nick Timiraos

This week, President Barack Obama is slated to offer prescriptions for an economy hobbled by stagnant job creation and an ailing housing market. The White House is under pressure to come up with new fixes that don’t require asking Congress for more money.

One idea that sounds easy enough: stimulate consumer spending and stem further carnage in the housing market by allowing more homeowners to refinance. The government, relying on mortgage-finance giants Fannie Mae and Freddie Mac, could refinance millions of loans, freeing up cash for more consumers.

The White House is evaluating how to revamp refinance programs because U.S. mortgage rates are near their lowest levels in more than 50 years—about 4.2% for a 30-year fixed-rate loan.

Any initiatives would likely rely on banks to refinance borrowers with loans backed by Fannie and Freddie, and changes to existing programs would also need the blessing of the firms’ independent regulator, the Federal Housing Finance Agency. On Friday, the agency filed suits against 17 banks to recoup unspecified damages on about $200 billion in risky mortgage investments, which analysts said could further complicate efforts to have banks refinance more at-risk borrowers.

Refinancing doesn’t attack two of the biggest housing challenges—high rates of underwater borrowers and unemployment. But it could help by “effectively immunizing a segment of mortgage borrowers out there, making them more resilient to economic pressures,” says Guy Cecala, publisher of Inside Mortgage Finance.

Many homeowners haven’t been able to refinance because they don’t have enough equity or because they can’t qualify under lending rules that are more rigid than when they took out their original loans.

If three-quarters of all borrowers with government-backed loans with rates above 4.5% were to refinance, that would deliver $70 billion in annual savings to as many as 30 million homeowners, according to an analysis by mortgage-market consultant Alan Boyce and Columbia Business School economists Glenn Hubbard and Christopher Mayer.

They further estimate that most of the savings would go to borrowers with loans of less than $200,000—frequently households that earn less than $70,000 a year. Lowering the rate on a $200,000 mortgage to 4% from 6% yields about $3,000 in annual savings, which means the plan would function “like a long-lasting tax cut,” they wrote in their proposal.

In the past, refinancing waves triggered consumption as homeowners spent their newfound cash on other goods and services. But some economists argue that today a refinancing wave might provide less of a lift because more borrowers are using the extra cash to pay down other debt and to rebuild savings.

Borrowers in a strong enough position to refinance “may have a lower propensity to spend out these dollars than a borrower who has been living closer to the edge,” says Jay Brinkmann, chief economist at the Mortgage Bankers Association.

The government doesn’t have to spend money to refinance, but such programs aren’t free. Savings to homeowners come at the expense of bondholders, as mortgage-backed securities that pay off today will leave investors with cash to invest at much lower yields. Among the largest investors in those bonds are Fannie and Freddie. Pension funds and banks also would be hit.

Thomas Lawler, an independent economist in Leesburg, Va., argues that bondholders have earned a “strange windfall” over the past few years because of various frictions that have prevented homeowners from refinancing.

One of the great puzzles of the current crisis is why more homeowners haven’t tapped an existing White House plan, the Home Affordable Refinance Program—rolled out in June 2009—that allows underwater borrowers with loans backed by Fannie and Freddie to refinance. While 838,000 homeowners have used the program, that’s far short of the hoped-for four million to five million.

In order for refinancing to deliver any kind of economic boost, policy makers will have to tackle a series of technical wrinkles that have doomed current efforts.

• First, Fannie and Freddie have required lenders to “buy back” defaulted loans when they can find an underwriting defect. Banks have been reluctant to refinance risky borrowers and are charging hefty premiums to compensate for the “buy back” risk.

“Everyone’s looking at lending and saying, ‘This is not attractive,’ ” Mr. Mayer said. Fannie and Freddie could help, he said, by agreeing to indemnify lenders against buy backs on Home Affordable Refinance Program loans. That would also give lenders an incentive to do more refinancing, because every new refinance would mean one fewer potential “buy back.”

• Second, Fannie and Freddie began charging higher fees for riskier borrowers, including those who are underwater, more than two years ago. Some economists say that because Fannie and Freddie are already on the hook if those loans go bad, they’d be better off waiving fees so that borrowers can reduce their monthly payments.

• Third, refinancing borrowers who are underwater has proved difficult because borrowers have second mortgages or mortgage insurance from companies that must sign off on the new loan.

Also, economists say waiving appraisal fees and offering a short, standardized application could reduce closing costs, which can average around $4,000 on a $200,000 loan. “If you’re already upside-down, are you going to want to spend more money on your home?” says Sam Khater, senior economist at CoreLogic Inc.

Other hurdles will be harder to fix. Consolidation in the mortgage industry has led to reduced capacity. This means that the largest U.S. banks have artificially held rates higher relative to their borrowing costs in order to deal with a surge in applications. Spreads eventually fall as the banks work through the backlog.

Lowering barriers to refinancing—either by gaining the approval of Fannie and Freddie’s independent regulator or, failing that, through legislation—is crucial. Without that, a new administration initiative is likely to help a few borrowers at the margin but do little to lift the economy.