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Opinion, commentary and analysis on everything that makes the U.S. housing economy tick -- not to mention the ghosts in the machine, too. Written by HW's team of editors and reporters each business day.

What pols and pawns won't tell you about FHA Short Refi

December 20, 2010
On Dec. 8, Nick Timaraos and Alan Zibel at The Wall Street Journal ran a story about the FHA Short Refinance program under the headline "Fannie, Freddie pressed on mortgages." The gist is this: The Obama administration is trying to enlist Fannie Mae's and Freddie Mac's participation in the Federal Housing Administration's short refi program. The program, aimed at underwater borrowers who are current on their mortgage, requires lenders write down the existing mortgage and then refinance it with an FHA loan. Timaraos has been following this program, as well as the effort to drag the government-sponsored enterprises into it, for months, but he and Zibel really hit a nerve with the December article. A number of mortgage prepayment analysts, sensitive to the prepayment and price implications for mortgage securities, quickly responded with research notes. (HousingWire covered several as they arrived here, here and here. Who's jawboning? It appears the only administration official pressuring the GSE to participate in the FHA program (at least publicly) is David Stevens, the FHA commissioner. The WSJ report quotes Stevens as saying resistance by lenders has been exasperating, and if institutions won't participate, that's "short-sighted." Reuters, The Washington Post and CNBC also reported Stevens' "short-sighted" comments. Kick 'em when they're down Why not blame Fannie and Freddie for the failure of yet another born-undead plan to prevent foreclosures? Why not get highly visible reporters like CNBC’s Diana Olick to tell the world, "Fannie and Freddie hold the lions share of loans that would benefit from this, and the big servicers aren't going to jump in on their own without them." The humbled and muzzled GSEs are the easiest scapegoat on earth. They are no longer allowed to lobby their own position. Even reputed supporters like Rep. Barney Frank (D-Mass.) have distanced themselves, and a passel of pols is building its tower to the heavens on claims that Fannie, Freddie and pro-homeownership government programs precipitated the economic disaster. FHA short refi plan built to fail Fact is, the program is feeble, flawed and clear evidence the other "housing agencies" don't understand the legal structure within which the GSEs are operating. Big problem No. 1 (and shared with the rest of the Making Home Affordable band-aids): Participation is voluntary. The first lien holder must swallow a substantial writedown on a performing loan. As Stevens' explains it to the media, putting a performing but underwater loan through a short refi is like hedging against further home price declines. He told Reuters that writing down the loan now "really pays them off from any future risk has real economic value to these institutions." This is one-size-fits-all thinking. It ignores the fact that portfolio lenders, GSE guarantors and servicers of private loan securities have different economic objectives and face different operating constraints. But for the sake of argument let's say there is a generic "lender." What is the rational choice between a certain loss now and a possible loss in the future? Criteria will eliminate most borrowers anyway Second, eligibility is not a simple matter. Twelve primary conditions filter out many borrowers, including the ones most deeply stressed. News articles have not listed out the eligibility criteria. Is that because seeing them in black and white might make the program's practical limitations obvious? I have enough faith in readers to think it would. So here they are, verbatim from HUD's Mortgagee Letter 2010-23: 1. The homeowner must be in a negative equity position; 2. The homeowner must be current on the existing mortgage to be refinanced; 3. The homeowner must occupy the subject property (1-4 units) as their primary residence; 4. The homeowner must qualify for the new loan under standard FHA underwriting requirements and possess a "FICO based" decision credit score greater than or equal to 500; 5. The existing loan to be refinanced must not be a FHA-insured loan; 6. The existing first lien holder must write off at least 10% of the unpaid principal balance; 7. The refinanced FHA-insured first mortgage must have a loan-to-value ratio of no more than 97.75%; 8. Nonextinguished existing subordinate mortgages must be re-subordinated and the new loan may not have a combined loan-to-value ratio greater than 115%; 9. For loans that receive a "refer" risk classification from TOTAL Mortgage Scorecard (TOTAL) and/or are manually underwritten, the homeowner's total monthly payment, including the first and any subordinate mortgage(s), cannot be greater than 31% of gross monthly income and total debt, including all recurring debts, cannot be greater than 50% of gross monthly income; 10. FHA mortgagees are not permitted to use premium pricing to pay off existing debt obligations to qualify the borrower for the new loan; 11. FHA mortgagees are not permitted to make mortgage payments on behalf of the borrowers or otherwise bring the existing loan current to make it eligible for FHA insurance; and 12. The existing loan to be refinanced may not have been brought current by the existing first lien holder, except through an acceptable permanent loan modification as described below. In addition, permanently modified loans may be eligible: a Making Home Affordable Modification Program, or HAMP, loan in the month following the date the modification became permanent; but a non-HAMP loan must be current and have made three monthly payments on time. Whew! Did you get through all that? The criteria eliminate FHA borrowers, including those who cut off access to regular FHA refinancing by taking a second mortgage subsequent to their FHA loan. They also eliminate unemployed borrowers as well as those with diminished incomes who paid the mortgage but let other obligations slide (the "refer" class who must satisfy DTI limits and the sub-500 FICOs). No wonder WSJ's Timiraos and Zibel reported that the program received just 61 applications and completed only three loan modifications during its first three months. What are the borrower and lenders' incentives? A thoughtful consideration of borrower and lender's incentives/disincentives shrink the number of potential short refis still further. Portfolio lenders best fit Stevens' generic lender, who, if rational, will leave a performing loan unmodified. But they might be willing to let borrowers with modified loans use the program. In its Aug. 10 "HAMP: A Progress Report," Amherst Securities noted banks in many cases are not carrying modified loans at par (or have taken loan loss allowances against them). That means that banks might lose little more or even take a small gain on the transaction. At first blush, the economics may appeal to borrowers. But there are hefty transaction costs. The obvious ones are the usual loan origination costs as well as the upfront FHA insurance premium. Moreover, as Barclays stressed in reports in April and June, the short refinance takes a big bite out of a credit score. Only borrowers expecting to become delinquent may want to take that hit. Servicers of PLS have a similar economic dis-incentive: Principal and interest on performing loans helps support obligatory advances of P&I on delinquent loans. Moreover, their ability to modify loans is legally constrained by the specific terms of each securitization. To qualify for the safe harbor created by Congress to protect them from investor lawsuits, the loan must be in danger of imminent default. For this reason, analysts generally agree that the likely candidates are again already modified loans. Unfortunately, many modified borrowers will find the program unappealing. In an Aug. 13 weekly report, analysts at JPMorgan noted that modified rates under HAMP could be as low as 2%, while a new FHA loan carries the market rate. (I'd add there's still the matter of FHA insurance premiums.) Amherst did the math in its Aug. 10 report: The monthly payment on a $200,000 loan at 2% is $739. Assuming the borrower is paying 5.5% on the new loan, the principal must be written down to $130,000 to hold the payment constant. That's 35%. Moreover, Amherst suggests the program is so "cumbersome" that PLS servicers must do a lot of work to qualify a borrower and may not bother unless they can protect the second lien. Big potential second lien problem It has been demonstrated so often now it must be a cliche: The four largest mortgage servicers also own almost half the outstanding second liens. To what degree hasn't been sorted, but often enough they are the same bank. Not only is this a huge roadblock to modifications in general, it undermines the FHA short refi program. If the second lien holder doesn't agree to re-subordinate, there's no refinance. Until the administration and Congress man-up to the second lien snafu, none of these HAMP-ster programs can succeed. There's another flaw. Amherst Securities put it bluntly: Given the design, the second lien holder can "game" the first. Here's how the grift works: The new FHA mortgage cannot have an LTV of more that 97.5%, but there is no minimum. The second lien holder must re-subordinate, but so long as the CLTV does not exceed 115%, it doesn't have to write down principal. So, if the servicer is affiliated with the second line holder, they would chose to take as much of the loss in the first mortgage, get cashed out by FHA and put the second lien in a much stronger position should the borrower ultimately default. Barbed wire obstacles for GSEs Assuming the GSEs would make the uneconomic choice and write down a performing loan, the loss would have to be offset by earnings or draws on the Treasury. Those quarterly draws are highly visible, politically potent events that make the risk to taxpayers explicit. There are operational complications as well. In order to modify a loan, the GSEs must buy it out of the pool. And, as analysts at Barclays Capital noted in a report last September, the FNMA trust agreement does not permit buying out current loans. I checked the Freddie trust agreement. It permits the agency to repurchase a loan if information from the borrower or servicer indicates default is imminent due to borrower incapacity, death or hardship or other extraordinary circumstances. These documents can be rejiggered, but like an adjustment to any complex contract, it needs be done carefully (takes time). There are other problems. If GSE participation is implemented through servicers, what is to stop them from protecting their second liens? Loans with mortgage insurance are problematic as well. As it now stands, there is no agreement between mortgage insurers and GSEs to share the loss on a principal writedown. And why would mortgage insurers agree to that? The premiums they were receiving from current borrowers cease, and FHA collects the premium on the refi loan. Given the obstacles, analysts expect any GSE participation to have a limited effect on prepayments and to generate minimal new Ginnie Mae supply. JPM analysts estimated no more than 400,000 loans (about $70 billion) would be eligible. Credit Suisse estimated 5% to 15% of the 105+ LTV GSE loans made from 2005 to 2008 ($11 billion to $34 billion). And Barclays, applying Freddie Mac loan level data (Freddie discloses second lien where known and MI) across the board, estimated just 1% to 6% of loans in higher coupon fixed-rate 2006 to 2008 vintage securities would qualify. If you've followed thus far, you will agree the eligible borrowers who actually would pursue an FHA short refi are, however, much fewer. Just one big hitch: conservatorship Criticize the GSEs all you want for not jumping on the FHA's bandwagon, but their regulator, the Federal Housing Finance Agency, has the duty and the authority as conservator to prevent them from doing anything but conserve assets, minimize corporate losses and pursue their statutory mission. The GSE missions are spelled out in their charters (paraphrased here, links to the charter acts on GSE websites): To provide stability in the secondary market for residential mortgages; To respond appropriately to the private capital market; To increase the liquidity of mortgage investments and improve the availability of investment capital for residential mortgage financing; To promote access to mortgage credit. Nowhere in the charter acts is anything said about stabilizing the value of housing stock or subsidizing home ownership by writing a check for part of the principal. The GSE conservator's powers and duties are defined in the Federal Housing Enterprise Financial Safety and Soundness Act of 1992, as amended by The Housing and Economic Recovery Act of 2008 (HERA). Specifically, the agency is endowed with "all the powers of the shareholders, the directors and the officers of the regulated entity and conduct all business of the regulated entity." The conservator's role is to put the dnterprise in a sound and solvent condition, to carry on its business and to preserve and conserve its assets and property. Note also that FHFA is an independent federal agency. That is, the director is appointed by the president with the approval of the Senate. The director is "advised" by the Federal Housing Finance Oversight Board, made up of the director, the secretaries of the Treasury and of Housing and Urban Development and the chairman of the Securities and Exchange Commission. However, and this is key, the law limits the powers of the board. It may not exercise any executive authority, nor may the director delegate to it any of the director's functions, powers or duties. If that were not clear enough, the law specifies that, when acting as conservator or receiver, FHFA "shall not be subject to the direction or supervision of any other agency of the United States." In other words, FHFA — and the GSEs — cannot be compelled to participate in the FHA short refi program. Can Obama's FHFA director permit short refis? Last week I wrote about "The behind-the-scenes push to get rid of Edward DeMarco," the acting director of FHFA. Apparently he took his job description too literally when he sent 64 subpoenas to issuers, servicers and trustees regarding private mortgage securitizations the GSEs own. Next thing, Senate banking committee Chairman Chris Dodd (D-Conn.) and ranking member Richard Shelby (R-Ala.) wrote the president asking him to appoint a permanent director. In November, President Obama named Joseph Smith, an attorney and North Carolina banking commissioner to the post and the banking committee approved it Dec. 15. Now the Senate has until the end of the year to approve it. Laughably enough, the only opposition to Smith that has materialized comes from ranking member Shelby, who was widely quoted last week as saying, "The first confirmed director must hit the ground running — equipped with the skills and experience needed to be a strong regulator free from influence by the current administration. In other words, we need a watchdog not a lapdog." Does Shelby think Smith will be soft on GSE principal reductions but not on banks' liability for their misrepresented and badly serviced loans? Having looked closely at the DeMarco affair, I'm confident the law is too explicit to provide Smith or anyone else latitude to act differently as conservator than DeMarco has. And, for added ballast, DeMarco resumes his position as deputy director if Smith is confirmed. Plus there's a watchdog for the watchdog, one Shelby did not object to. The Senate confirmed the first FHFA inspector general, Steve Linick, a career federal prosecutor, "to ensure that FHFA operates in accord with its chartered purpose, and to avoid inappropriate political interference." Josh Rosner at Graham Fisher & Co. made this point in "FHFA, the GSEs and HAMP". The Inspector General's duties include overseeing and reporting to Congress "on any waste, fraud or abuse" within FHFA and on its "compliance with its congressionally mandated purposes and powers." His nomination was approved unanimously by the Senate banking committee, and he was one of dozens of nominees unanimously confirmed on Sept. 29. Moreover, he'd previously been nominated for the position by President George W. Bush, but the Senate failed to act on it. <> To conclude, it would pretty much take an act of Congress to get the GSEs to permit FHA short refis of loans it has guaranteed. Linda Lowell writes a regular column, called Kitchen Sink, for HousingWire magazine. 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.
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