Meanwhile, the political outlook for actually doing something about it has gotten worse, because the business community and cowardly Democrats failed to rally behind the president’s plan, giving Republicans the political head room to continue peddling their Rotary Club nonsense that what’s holding back the economy is a crushing tax burden, stifling regulations and all-consuming worry over the budget deficit.
Given the almost certain prospect of a continuing political stalemate, the president’s best option is to use the power he’s had all along to deliver tens of billions of dollars in additional stimulus by allowing millions more households to refinance their mortgages at today’s low rates.
I’m not talking about significant modifications to troubled mortgages, which the banks and mortgage bond investors have done a fabulous job of preventing since the last years of the Bush administration.
Nor am I talking about providing taxpayer relief to homeowners who have fallen behind on their payments and are facing foreclosure.
I’m talking about the millions of households that are paid up on mortgages that still have interest rates of more than 5 percent and could use the lower rates engineered by the Federal Reserve to reduce annual payments by an average of $2,500 a year.
Here’s a statistic that tells you pretty much all you need to know:
Back in the recession that began in 2001, roughly 85 percent of households that were eligible to refinance their mortgages did so, with an average decline in interest rates of about 1.3 percentage points. That freed up about $67 billion each year in bond payments that could be spent on other things.
This time, only about 25 to 30 percent of mortgages has been refinanced, despite the lowest interest rates since the Great Depression. The average decline in rates on those refinanced loans has been less than half a percentage point, resulting in $45 billion in overall savings to borrowers.
The biggest reason for this refinancing gap was a decision by Fannie Mae in 2008 to increase the fees it charges to guarantee all new loans, including refinancings. The fee varies by borrower, but is particularly steep for those with low or middling credit scores, those with loans that are 90 to 125 percent of the current market value of the house and those living in areas where home prices declined the most.
Given the shoddy underwriting during the credit bubble, this may have seemed like a reasonable step for Fannie to take as it related to guaranteeing new loans. But in terms of refinancing loans that it already guaranteed, it was rather short-sighted. Refinancing would have lowered the monthly payments and, therefore, the probability that the homeowner would default, which has turned out to be Fannie’s biggest risk and the biggest contributor to its quarterly losses.
Essentially, Fannie’s clever strategy was to use its near-monopoly power to charge higher fees for assuming smaller risks knowing full well that the extra fee would discourage refinancing. The fees ranged from half a percentage point to three percentage points, which for many pretty much wiped out the potential benefit of refinancing.
Why did Fannie do that? Because in addition to being in the business of providing mortgage bondholders a guarantee, or insurance, against the risk of default, Fannie also owns a huge portfolio of those bonds. And as a bondholder, refinancing a loan means it would receive less money every month from the borrower. The extra fees were designed not only to discourage refinancing, but to make up for any decline in monthly cash flow.
Historically, whenever Fannie raised or lowered fees, its twin, Freddie Mac, would quickly follow. But this time when it did not, Freddie Mac executives were ordered by its new regulator to do so, apparently with the idea that it would lower the cost of the government bailout. What may have been good for American taxpayers in the short run, however, turned out to be bad for the economy.
Also contributing to increased refinancing costs were the handful of big banks that own or service most of the mortgages in the United States. With the demise of aggressive (and foolhardy) players such as Countrywide, the mortgage banking industry went from being hyper-competitive in terms of price to being not very competitive at all. As a result the spread — the difference between what the banks pay for money and what they charge — widened considerably.
The effect of all this was to thwart the impact of Fed’s ultra-low interest rate policy by allowing Fannie, Freddie and the big banks to capture much of the benefits rather than having them pass through to households and the broader economy. Those who still found it worthwhile to refinance tended to need the help the least — wealthier households with higher credit scores and lower loan-to-value ratios. Middle-income borrowers whose home values had fallen below the level of the outstanding loan were largely shut out. The result: a weaker economy, more foreclosures and a steeper decline in house prices.
Over the past two years, there have also been numerous proposals for how to fix this problem by ordering Fannie and Freddie to roll back its fees and by somehow limiting the spreads charged by mortgage bankers. But these have been quietly opposed by bondholders who didn’t want lower interest payments and by industry executives and some top administration officials who warned that it would raise the interest rates on all new mortgages in the future. Some Republicans also were so determined to kill Fannie and Freddie once and for all that they couldn’t stomach the idea of using them again as instruments for government management of the mortgage market.
Now, however, with prospects dimming for other stimulus proposals and the housing market still fragile, a bipartisan consensus for mass refinancing may be emerging. Obama mentioned it in his recent speech to Congress. And a Senate hearing last week found support from both parties as well as a number of prominent economists.
The best proposal I’ve seen comes from Glenn Hubbard, a former economic adviser in the Bush White House, Chris Mayer, his colleague at Columbia Business School, and Alan Boyce, a trader in mortgage bonds. The trio’s idea is to order Fannie and Freddie to reduce its fee to a flat 4
10 of a percent for refinancing any fully paid-up loan that it already guarantees. The process would be streamlined, eliminating appraisals and income verification. The fee would be lower than now, but higher than it has been in normal times, and sufficient to offset the reduced monthly cash flow from refinanced borrowers.
As for the banks, those that accept a lower refinancing fee of 3
10 of one percent would be granted immunity from lawsuits stemming from loans issued during the bubble — a huge cloud that hangs over the big banks. Those who refuse the arrangement would lose their ability to sell their mortgages to Fannie and Freddie, which are pretty much the only games in town since the housing bust began.
The big losers would be the private holders of mortgage bonds — mostly pension funds, hedge funds and other money managers, along with foreign governments — who might take solace in the fact that they have enjoyed three more years of interest payments at the old, higher rates than they would have if the Fed’s monetary stimulus had been allowed to pass through to homeowners. And because of the salutary effect of lower mortgage rates on the economy, bondholders eventually would recoup a fair portion of their “lost” income through reduced foreclosures.
Hubbard, Mayer and Boyce estimate that their plan could allow as many as 25 million households to refinance mortgages and have an extra $70 billion every year to spend and invest — the equivalent of a $70 billion-a-year tax cut that can be had at no cost to taxpayers.
A new wave of mortgage refinancing is not an economic silver bullet, but it is a positive step that everyone can agree on conceptually and can be implemented quickly within existing law. What’s been missing so far has been the cooperation of Fannie and Freddie’s regulator and a determination on the part of the White House and the Treasury to get over all their technical objections and political qualms and just get it done.