How Underwater Mortgages Can Float the Economy – The New York Times

Recent calls for another federal stimulus package raise an important question: Before considering costly short-term measures to raise overall consumer demand, have we done enough to ensure that financial markets will work properly and lead us to recovery?

For housing — the sector at the center of the crisis — the answer is no. But the good news is that it might be possible to improve the housing market and invigorate the economy in a way that won’t require a costly stimulus package.

In a normally functioning mortgage market, almost all homeowners would have refinanced their mortgages to take advantage of low rates. Yet today, low interest rates are doing little to stimulate the housing market because of other stresses, including declines in house prices, falling household incomes and banks’ wariness of making loans.

To change this dynamic, we propose a new program through which the federal government would direct the public and quasi-public entities that guarantee mortgages — Fannie Mae, Freddie Mac, Ginnie Mae, the Department of Veterans Affairs loan-guarantee program and the Federal Housing Administration — to make it far easier and quicker for homeowners to refinance.

This program would be simple: the agencies would direct loan servicers — the middlemen who monitor and report loan payments — to send a short application to all eligible borrowers promising to allow them to refinance with minimal paperwork. Servicers would receive a fixed fee for each mortgage they refinanced, which would be rolled into the mortgage to eliminate costs to taxpayers.

Consider a family that bought a home in 2006 for $225,000, taking out a $200,000 fixed-rate mortgage at the prevailing 6 percent interest rate with monthly payments of about $1,200. That home is now worth about $175,000. The family still owes $189,000 and thus cannot refinance because they are underwater.

But under our proposal, the family would be offered a new mortgage at today’s prevailing rate of 4.3 percent. The family would see a 15 percent decline in their monthly mortgage payment, saving more than $2,000 per year. This would not only help homeowners through the current crisis, but would be the equivalent of a 26-year tax cut of more than 4 percent of income, assuming the family spends around 30 percent of income on housing.

There are about 37 million outstanding mortgages now guaranteed by the federal government. Analysts at Morgan Stanley and JPMorgan Chase have crunched the numbers on programs like ours, and have estimated that it would save homeowners, most of them middle class, about $50 billion a year in mortgage payments.

In fact, we believe a well-designed program could produce even bigger reductions in mortgage payments. While households tend to save an appreciable percentage of any temporary stimulus like a one-time tax rebate, this reduction in mortgage payments would be permanent, likely leading to a substantial increase in spending for households that have been hurt by the recession. Lower mortgage payments would also allow many struggling families to stay in their homes and stave off foreclosure.

This program would have the substantial added benefit of reducing the endless stream of fire sales of previously foreclosed houses. Stabilizing house prices reduces the incentive for other underwater homeowners to walk away from their homes, and gives all homeowners increased confidence in the economic value of their house.

What would the government have to do to make the program work? First, the agencies would issue new mortgage-backed securities to cover the refinanced mortgages, using the proceeds to pay off the loans held in the existing securities. This is exactly what happens now when borrowers refinance; the agencies would simply have to be prepared to do it on a much larger scale. None of this would affect their cash flow or their ability to cover the risks of default on the loans they have backed.

 True, the government has tried a similar program with poor results. More than a year ago, the Treasury announced the Home Affordable Refinance Program to offer help with expedited refinancing for borrowers, including those whose loans were worth up to 125 percent of their homes’ values. Yet only a little more than $1 billion of mortgages with loan-to-value ratios above 105 percent have been refinanced under the program, a drop in the bucket.

What went wrong? First, the program was not widely publicized relative to the federal government’s efforts to help with more modest loan modifications. Second, the refinancings require substantial upfront costs for borrowers. Third, many borrowers — those with second liens or shaky incomes — were locked out. (About 20 percent of all borrowers with federally backed mortgages have a second lien.) Last, many borrowers do not know the current value of their homes, and are reluctant to pay to get an appraisal only to be turned down for a refinancing.

THE program we propose addresses these issues. It would have minimal costs, which we would roll into the cost of the mortgage rather than forcing homeowners to make a big upfront payment. For mortgages with second liens, the government could request a blanket approval from all servicers to allow the new mortgages to have priority over existing second ones. It is in the interest of the servicers of second liens to allow such refinancings, because they reduce payments on the first mortgage and thus lower default risk on the second lien.

Of course, there is no such thing as a free lunch. These gains to homeowners and to the economy would come from paying off the holders of the current mortgage-backed securities. And many of those bondholders would no doubt prefer to continue to get the higher interest payments.

Yet part of the reason that mortgage bondholders receive a high interest rate is that mortgage securities can be paid off early if mortgage rates fall. Additionally, these bondholders received a big windfall in 2008 when the federal government explicitly guaranteed their bonds against losses from defaulting homeowners.

Would the refinancing program increase the federal budget deficit? No. In fact, the change will probably reduce the federal deficit in the long term. Taxpayers are already on the hook for hundreds of billions of dollars of likely losses from loan guarantees to Fannie Mae and the other agencies. If we can lower mortgage payments for struggling homeowners, it will reduce future foreclosures on federally backed loans, providing savings to taxpayers.

Are there legal barriers to putting our program in place? For most homeowners, the Treasury could start today. However, for homeowners whose mortgages are deeply underwater, our proposal might require modifying the law to enable Fannie Mae and the other agencies to float bonds backed by the new mortgages. That’s not insurmountable.

For two years now, the Federal Reserve has been cutting interest rates and loosening the money supply, which would ordinarily lower the cost of owning a home enough that buying is more attractive than renting. Yet tight credit is preventing the market from functioning. To open things up, the government — which is already financing nearly 19 out of every 20 new mortgages — needs to help struggling homeowners get more manageable monthly payments. Is there a better approach to help bring the economy back?


By Glenn Hubbard and Chris Mayer, senior vice dean of the Columbia Business School. Read the Op-ed online at the New York Times.