Homeowner Bailout Does Reflect Some Market Realities
In the last few days, I’ve read a chunk of the faith-based commentary on the Administration’s new Homeowner Affordability and Stability Plan. The media, whether they pretend it’s news (in which case their coverage is “infotainment,” or blogging from an assigned workplace during defined working hours) or call it commentary or opinion (in which case, it’s proto-blogging), do not make extensive use of facts about any of the mortgage businesses or markets implicated in the current economic disaster. Or, worse yet, facts are invented or misappropriated to seemingly suit a writer’s deadline or agenda. (Or both.) This coverage doesn't provide much of the real-world context in which all of these bailout and rescue plans must actually function -- or against which their likelihood of success or failure actually needs be assessed. This is not just an ivory tower complaint. Many of the last Administration’s interventions unleashed serious “unintended consequences,” because they did not consider the context in which they were acting broadly enough. And the press has not been any better able to anticipate the garbled results. My first example of dithering without digging into the real market issues comes from an recent editorial in the Wall Street Journal (Dukes of Moral Hazard, Feb. 18). They focus on the first big element of the Plan, expanding refinancing for responsible homeowners:
Anyone with mortgages owned or guaranteed by Fannie Mae and Freddie Mac will be able to refinance to lower rates if his mortgage is between 80% or 105% of the value of the home. This is a sweet deal that is not available to renters looking to buy homes now.The Administration is not really covering new ground here -- they are addressing a problem embedded in the GSE charters that has prevented borrowers in good standing from refinancing existing GSE loans because falling home prices have reduced their equity below 20 percent of the property value. The GSE charters, created by Congress, prohibit the GSEs from financing (through a purchase or guarantee) more than 80 percent of the property value. If the LTV is higher, the loan must have third-party credit support. Historically, this credit support has been in the form of PMI, but in the bubble-building years, borrowers found piggy-back second mortgages less costly (because they were securitized and off-loaded into CDOs and yield-hungry funds). As much as the GSEs have tightened their credit standards, PMI underwriting is even tougher, and their insurance premiums have gone up to reflect the realities of mortgage risk. The really “sweet deal” out there is available to FHA borrowers (and this is why FHA lending and Ginnie Mae issuance is booming). In return for upfront and monthly insurance premiums, a home buyer or owner looking to refinance a private or GSE loan can borrow roughly 97 percent of the appraised value. For the time being, given the housing crisis, the FHA has been barred from risk-pricing those premiums. Even sweeter is the refi deal for existing FHA borrowers. If they are current, they can do a so-called streamlined refinancing, which eliminates most of the documentation and hassle -- including the requirement for a new appraisal. The rationale is -- I think -- a sound one: the borrower is current and even if the loan is “underwater,” the homeowner has clearly signaled that the house is a home and not a used up ATM. The FHA has the legal authority to operate this way and has used it since they introduced streamlined refinancing in the late 1980s. The GSEs followed suit -- sort of -- by reducing documentation and processing time. And they would waive the appraisal if the lender would provide “reps and warranties” that the original appraisal was still valid (an acceptable form of third party credit support, as it gives the GSEs recourse to the lender). Reps and warrants worked when home prices were going up, but they stopped working when home prices started down. The mortgage market has been well aware of this problem. The disparity between loan application activity reported by for government and “conventional” loan programs is clearly evident in the weekly MBA application surveys, and Mortgage Maxx AFS (another loan activity monitoring service aimed at estimating prepayments over short-term horizons) has been commenting for many months on the low completion rate of mortgage applications, largely owing to insufficient equity. For mortgage investors, this problem translates into an impediment to prepayments that, for example, extends the duration of a GSE MBS investment compared to a Ginnie Mae. Mortgage investors -- and the research analysts on the Street who track prepayments and other drivers of relative value -- have paid considerable attention to this issue over the last year or so. A lot of weekly research has been published addressing the topic, with many solid analysts suggesting that Congress would have to revisit this problem soon in order to provide this OBVIOUS relief to borrowers. It's hard to believe that the WSJ has missed this discussion, but can still quote from Credit Suisse-led research into redefault rates. Maybe they thought prepayment commentary was too technical. But it's hard to believe that the long-time GSE critics at WSJ missed Fannie Mae’s attempt earlier this month to streamline refinancings. The program change allows certain borrowers underwritten in its automated loan processing system to forgo a formal re-appraisal if they were applying for rate refis (called limited cash outs, because the loan amount could be raised slightly to cover fees and closing costs). The automated system uses current home price data and other information to perform a check on property value. Given other credit criteria are met, Fannie Mae was willing to accept this measure of value. To go farther would require either action by the Congress (oh no! not a lot of hearings and partisan debate and maneuverings, too!) or some form of credit support from the lenders, possibly backed by the kind of guarantees or credit enhancements authorized under EESA. I think it’s safe to say that the Administration is still working through the strategy it thinks will be easiest to institute and implement. OK -- so maybe that wasn’t fair to take an outright editorial to task for massaging the facts. Let’s take “news” coverage of the Plan instead. Both the Washington Post and the Financial Times make similar mistakes about fully streamlining GSE rate refis. Let’s move on to the next major component, the modification plan. The press seems to doubt it can work because it’s voluntary. A little fact checking will discourage that point of view. The Washington Post’s “Obama Proposes Package to Stave Off Foreclosures” (read it here) is a litany of shortcomings, including the assertion that the program would be voluntary.
"This is a major step forward to addressing the foreclosure crisis," said John Taylor, president of the National Community Reinvestment Coalition. "But the plan may not be aggressive enough. While the plan offers sweeteners to encourage lenders and homeowners to participate, its voluntary nature may blunt its impact."First of all, it will be required for recipients of FSP (the new name for TARP Capital Purchase Program). Those recipients include the largest U.S. and regional banks, who control at least 60 percent and more of outstanding mortgage servicing in the U.S. Secondly, the Administration intends federal financial services regulators to implement these guidelines among the institutions they regulate. There might be a delay drafting regulations and taking comments and all that, but it does not sound like it will be voluntary by any stretch of the imagination. The universal application of standardized modification procedures may also resolve a couple of the real-life obstacles to modifying loans in securities. Here’s the Financial Times, with “Housing Plan Aims to Reduce Monthly Bills”:
However, 62 per cent of the most problematic loans are held in securitised pools of mortgages, jointly owned by investors with different claims on the assets and managed by servicers. These will be difficult to modify. The legal arrangements in private mortgage pools, which vary enormously, frustrated earlier efforts to implement standardised loan modification programmes because of limitations on the number or type of changes that can be made.First of all, previous standardized loan modification programs have been voluntary, and they have maximized the moral hazard in modification by requiring the borrower be delinquent. I know how I’d feel if I started missing payments -- I’d be paranoid and defensive. I’d either be in full blame-others mode, or locked into denial. This program sets a debt-to-income trigger for eligibility -- also clean, but borrowers who want help won’t be told to call back when they are delinquent. Standardization speaks directly to the leading obstacle to modifying loans that have been securitized -- fear of investor lawsuit. There is variation across documents, but in general the governing documents employ a general servicing standard (I’m relying here not on recollection, but on testimony of Stephen Kudenholdt, head of the structured finance practice at Thacher, Proffitt & Wood LLP delivered November 14, 2008 in a hearing held by the House Oversight and Government Reform Committee). Typically the servicer is required to follow the accepted servicing practices it would employ “in its good faith business judgment” and which are “normal and usual in its general mortgage servicing activities” or in servicing loans for its own account. These include loss mitigation activities. The Administration guidelines in effect become the normal and usual practice. Not a bulletproof defense against lawsuit, of course, but it should give comfort to servicers (they still can only modify when the NPV of the modification is greater than the NPV of a foreclosure). I could be wrong, but I think this is primarily why JPMorgan Chase (JPM) CEO Jamie Dimon repeatedly asked for standardized modification practices during the House Financial Services Committee hearing last week on Tarp Accountability. (And, in fact, Mr. Dimon applauded this feature of the Plan to the Washington Post.) Another real-world feature of the Plan misunderstood in the press expands the Treasury’s funding commitment to Fannie and Freddie and increases their ability to buy loans and MBS by lifting their portfolio and debt ceilings. Here’s the NY Times, “Obama Housing Plan Tries to Slow Downward Spiral”:
A third, more vague component of the plan is aimed at propping up the mortgage market as a whole by having Fannie Mae and Freddie Mac step up their purchases of mortgages and mortgage-backed securities.Please. This misunderstanding could be cleared up with a single phone call to one of dozens of professional MBS traders, analysts and investors working in the Mid-Town area alone (just blocks from the Times Building, it should be noted). This provision of the Plan reflects an understanding of the real world dynamics of the MBS markets. The GSE’s portfolio purchases effectively established a floor on MBS prices when interest rate volatility or supply put them under pressure. In effect, the GSE’s purchases protected all the other investors, including the foreign central banks, pension funds, mutual funds, banks and insurance companies who have important stakes in the market. Capping those purchases may have pleased the critics of GSE systemic risk, but it pulled the rug out from under those investors. Simply put, soft demand for MBS means lenders have to raise the rate on loans packaged as MBS. The Federal Reserve has been buying MBS to supplement that demand, but it has been swimming upstream. These moves reassure foreign and other investors that the government is supporting the GSEs and that the GSEs will be allowed to support the MBS market. Frankly, I think this is key -- the Treasury is going to be issuing a lot of bonds in coming months and years, and the Federal Reserve needs dry powder to buy a few of those as well. The Plan isn’t perfect, and it’s clearly not finished, but in my humble opinion it reflects this Administration’s effort to get on the ground and figure out what works and doesn’t work in the actual mortgage businesses and markets that still exist. Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC.