Q&A for Hubbard-Mayer Mortgage Refinancing Proposal

Professors Mayer and Hubbard's plan to lower mortgage rates will not only provide a sizeable economic stimulus but also stem the decline in house prices, protecting the government — and taxpayers — from future losses. “Fundamentally, our proposal is about restoring normally functioning credit markets,” says Mayer. (This is the FAQ for original Hubbard-Mayer proposal from 2008 )

Q1: Who would be covered by our plan?

Our plan would cover any existing homeowner or new purchaser of a home who was able to document their income, show that they can afford the mortgage that they are taking out, and document that they are residing in their home as a permanent residence. Borrowers with good credit (say a FICO score over 700 and a debt-to-income ratio less than 36 percent) would qualify for our most favorable rate — 5.25 percent. Other borrowers with less favorable credit (lower FICO score or more debt) would pay a higher rate, but almost surely less than they are paying now. The plan would cover all mortgages that are below the conforming loan limit, which is currently $650,000. Owners of second homes or investment properties would not be covered by our plan, but almost surely would benefit if credit markets improve and house prices stabilize. Cash out mortgages would not be allowed under this program, although owners could add the closing costs in to the new mortgage balance. The plan would apply to all mortgages initiated on or before October 1, 2008.

Map "Amount of negative equity per mortgage holder"

Q2: Who would originate these mortgages?

Borrowers would go to a bank or a mortgage broker to refinance their mortgage. Fannie Mae, Freddie Mac and the FHA currently have a well-developed process for originating mortgages and have the capacity to originate millions of loans in a relatively short period of time.

Q3: How precisely would this proposal work for homeowners with negative equity?

Suppose you were an owner with a good FICO score (FICO = 710), documented income, and living in a home with a $200,000 first mortgage. Due to the housing market decline, your property is now worth $180,000. Under our plan, you would be eligible for a mortgage of $171,000 (a 95 percent loan-to-value). This mortgage would require a write-down of $29,000 to be shared equally between the lender and the government. Thus the lender would need to accept a write-down of $14,500 in order to receive a payment in cash from the government of $185,500. You would agree to a new mortgage of $171,000 (1). The combination of a lower loan amount and a reduced mortgage rate could cause your payments to fall as much as 20 percent or more, making the mortgage much more affordable on a cash flow basis. In return, you must give the government a lien on the property equal to 20 percent of the increase in value from the date of the new mortgage.

This lien would be based on the average changes in prices in your zip code as measured by a price index, rather than the actual appreciation of your house. Basing appreciation on an index would allow you to make improvements in the house without worrying that the government would own 20 percent of these improvements. If house prices have fallen between the origination date of the new mortgage and when you sell, you would not owe the government any money for the lien. If house prices rise after this mortgage, you would owe the taxpayers 20 percent of the appreciation of house prices in your zip code.

(1) Since Fannie Mae and Freddie Mac are limited by their charter to buying mortgage equal to at most 80 percent of the home value, the FHA might need to provide a second mortgage for the difference in LTV from 80 percent to 95 percent. The interest rate on your second mortgage would be set to be the same as on your first mortgage.

Q4: How precisely would this proposal work for homeowners with positive equity?

The process would be simple for the vast majority of borrowers with positive equity. As an existing homeowner, you would apply for a new mortgage from your local mortgage broker or bank no matter what your equity position was. As long as the LTV on your home is 95 percent or less, you would refinance freely into this new mortgage plan. (2)

(2) See Footnote (1), above.

Q5: How much would this plan cost the government?

We estimate an immediate fixed cost of $121 billion to the government.

To calculate the cost of the proposed fiscal stimulus plan, we allow any owner occupant who took out a mortgage when average rates exceeded 5.75 percent to refinance into a new, 30 year mortgage at 5.25 percent. The maximum allowed refinance amount is 95 percent of the current home value (95 percent current LTV), not to exceed the current conforming loan limit of $729,750. Eligible homeowners also cannot refinance to a larger loan than their total current loan balance. In other words, the refinance balance is equal to either the current loan balance, 95 percent of the current property value, or $729,750 – whichever is least.

If a homeowner’s current outstanding loan balance is greater than the amount to which he is allowed to refinance (i.e., if the current LTV on the property exceeds 95 percent) then refinancing would require a down payment equal to the difference between the current loan value and the maximum allowed refinance amount. However, homeowners would be allowed to write off a portion of that down payment – say up to $100,000 – so that refinancing would require out-of-pocket expenditures only for homeowners who are more than $100,000 underwater. In that case, our calculations suggest that 72 percent of owner occupants would be able to refinance with no down payment. We calculate the total cost of covering those write offs would be $242 billion. That cost would be split equally between the government and lenders, for a cost of $121 billion to the government.

Q6: What would be the fiscal effects of this proposal be?

Again assuming a write off cap of $100,000 when refinancing, we estimate that 72 percent of owner occupant homeowners would be eligible to refinance at no cost to them. Their monthly mortgage payments would fall by an average of $355, for a total national fiscal injection $7.1 billion each month.

Allowing mortgage refinancing as we have described above would reduce mortgage payments for almost 20 million homeowners who currently took out mortgages at times that mortgage rates were 5.75 percent or higher and meet our other criteria. The typical borrower would reduce his or her principal and interest payments by about $350 dollars, a total reduction in mortgage payments of nearly $100 billion per year. Of that reduction, about $16 billion per year of the reduction is due to interest savings with lower mortgage balances (HOLC effect), $39 billion is lower interest payments on remaining balances from homeowners who refinance at a lower rate (refinancing effect), and about $42 billion in reduced amortization payments associated with extending mortgages that had as few as 23 years remaining for a new 30-year term. Thus about $55 billion per year (HOLC and refinancing effects) would be a direct macroeconomic stimulus. The reduced mortgage amortization might also provide short-term benefits by helping relax other credit constraints that some consumers face due to reduced lending on credit cards, student loans, and auto loans.

The macroeconomic stimulus effect should also include an additional housing wealth effect. At the low end of our estimates, improved mortgage market operations would reduce house price declines by 10 percent. With an estimated aggregate housing valuation of about $18 trillion, housing wealth would increase about $1.8 trillion relative to what it might fall to without this program. If we assume a relatively low marginal propensity to consume out of housing wealth of 3.5 percent, U.S. consumption would rise by $63 billion relative to what would otherwise have occurred.

Combining these estimates gives a total macroeconomic stimulus of as $118 billion per year in lower mortgage payments and any new consumer spending due to a housing wealth effect. In addition to the direct macroeconomic stimulus, jump-starting the stalled housing market will increase employment in a variety of industries that depend on housing transactions (mortgage and real estate brokers, home supply companies, moving companies, etc.) as well as increase the efficiency of the labor market by reducing impediments to households moving to take another job.

"Table of Write Down Costs by Cap" (Excel)

Q7: What about houses with a home equity line of credit or a second mortgage?

Second mortgages and lines of credit appear to have grown rapidly and have become a problem in negotiating workouts on first mortgages (senior liens). Our proposal to share losses would apply equally to all lenders, whether they are in the primary or secondary position. Suppose you were a borrower in our example, above, but instead you have a $190,000 first mortgage and a $10,000 second mortgage. In this case, your second lender would have to agree to receive a $5,000 cash payout. In some cases today, second lenders are holding back from approving transactions in order to demand a greater payout (a common “hold-up” problem in economics). We have two methods to address this problem. First, lenders must make a blanket agreement to either accept this payout in all cases (including first and second liens) or none at all; they cannot choose to participate on a loan-by-loan basis. If second lenders continue to hold up the process, legislation might be required to force participation.

Q8: How would lenders determine the property value?

Property values would be determined by a 3rd party appraisal using an appraiser from the approved list set by the FHA. Appraisers must certify that they have no conflicts of interest. However, all appraisals must also be checked using an automated valuation model that uses computer models to verify the appraisal. Appraisals that appear too high relative to the automated valuation model will require additional documentation, such as evidence that the borrower made home improvements. If a discrepancy still exists between the appraisal and the automated valuation, the lender would be required to provide a second independent appraisal to confirm the valuation.

Q9: How would Fannie Mae and Freddie Mac reduce mortgage rates without legislative changes?

In order for Fannie Mae and Freddie Mac to lend at a 5.25 percent rate, government intervention is required to allow these institutions to borrow at a lower rate and thus pass along lower rates to consumers. Despite the semi-nationalization and explicit guarantee from the federal government, Fannie and Freddie debt still trades at a large spread to Treasury rates. (As of Thursday, 10/8, GSE debt was trading near 5.3 percent, about 170 basis points above the 10-year Treasury.) There are at least a couple ways to fix this:

A) Federal Reserve will offer to swap Fannie or Freddie debt for an equivalent Treasury (modeled after the Term Securities Lending Facility at the Federal Reserve Bank of New York).

B) Treasury debt is issued and the proceeds would be lent to a special purpose vehicle (SPV). The SPV is merely a pass-thru, and lends to GSEs at Treasury rates. (This plan is modeled after commercial paper SPV.)

If new Treasury securities are used, eventually Congress would need to approve additional increases in the national debt. Of course, unlike normal deficit spending, this increase in the debt ceiling would be backed by secured credit in the form of mortgages on American homes. As well, this government debt would replace bank debt or government-guaranteed agency debt, so overall American indebtedness would not rise and there is little incremental increased risk for taxpayers.

In recent days, the Federal Reserve, in conjunction with other banking regulators such as the Office of the Comptroller of the Currency, have submitted a plan to reduce the risk-weighting on Fannie and Freddie debt from 20 percent to 10 percent. While this step would likely help reduce interest rates on Fannie and Freddie securities, it would still not have the same effect as swapping their securities for Treasury debt. Of course, the government would face some prepayment risk, but such risk is relatively small given the low rate of interest on the mortgages that would support the new Fannie and Freddie securities.
Q10: How does this plan relate to the recently approved Emergency Economic Stabilization Act of 2008?

This plan is especially helpful in combination with the Stabilization Act. Shoring-up house prices increases the value of the securities that the Government would buy, thereby minimizing the net cost to taxpayers if the plan were to be implemented. In addition, this plan can be started right away through the government’s conservatorship in Fannie Mae and Freddie Mac and its control of the Federal Housing Authority, providing an immediate stimulus to the economy and to the bulk of homeowners. By moving an appreciable amount of mortgages off bank balance sheets to the government’s balance sheet, this plan helps recapitalize the banking industry.
Q11: What are the government’s obligations and potential losses from their existing loan guarantees and mortgage-backed securities?

The US government has at least $5.8 trillion of exposure to mortgages and mortgage-backed securities.

The government has committed $200 billion to ensure that the GSEs Fannie Mae and Freddie Mac retain positive net worth. (See www.secinfo.com). Fannie and Freddie have a total of about $5 trillion in outstanding debt and mortgage backed securities, which the government would likely decide to guarantee, although it has not yet explicitly done so, if losses exceeded the $200 Billion. Fannie and Freddie bought $60 billion in loans from IndyMac upon its failure.

The government explicitly guarantees $428 billion in outstanding mortgages through Ginnie Mae, whose loans originate through the Federal Housing Association, the Department of Veterans Affairs, the Rural Housing Service, and Public and Indian Housing. (See www.ginniemae.gov - Issuers' pages).

The government has agreed to absorb $270 billion in Wachovia’s losses through the FDIC. (See www.fdic.gov - FDIC September 29, 2008 press release).

The government has agreed to provide $85 billion in loans to A.I.G. through the Treasury and thus is at risk for additional losses through AIG’s portfolio. (See www.federalreserve.gov - FRB September 16, 2008 press release).

The Federal Reserve Bank of New York has $29 Billion of former Bear Stearns securities, plus additional securities it holds as collateral against short-term loans to a variety of financial institutions.
Q12: Why not involve the bankruptcy courts and consider “mortgage cramdowns”?

The bankruptcy courts do not have the capacity to handle millions of underwater homeowners, so any resolution through the courts would be highly uncertain and take years to resolve. The program we propose also accomplishes many of the goals of bankruptcy reform by allowing indebted homeowners with negative equity to get out from under troubled mortgages now. It covers all homeowners, so there is no need to consider the circumstances of any individual homeowner’s transaction and the plan respects the fact that many homeowners did not understand the mortgages that they were getting into. Finally, by avoiding the courts, this plan does not restrict the ability of the private mortgage market to eventually recover. Moving mortgage debt into bankruptcy courts could well reduce future credit availability and hamper long-run economic growth and homeownership.

Q13: Why can’t efforts to work with servicers or put a moratorium on foreclosures help solve the problem?

Despite the best efforts and intentions of proponents, reforms like HOPE NOW and explicit encouragement to servicers to modify loans have not been able to solve the problem over the last year. Servicers are not compensated for successfully working out mortgages, so they have no incentives to put the effort and cost into real workouts.

In a few cases, servicers have tried large-scale workouts, but the bulk of those loans have re-defaulted in a relatively short period of time. Given the poor initial underwriting of subprime and Alt-A mortgages, serious workouts will require re-underwriting the mortgages one-by-one. Delays in foreclosures will not help if servicers are unable to handle workout effectively and will surely reduce the amount of future credit available as Karen Pence showed in her research. Our plan would provide for individual re-underwriting of mortgages. Moving any loan with the possibility of repaying back to a single owner/servicer will have enormous advantages of burying a seriously flawed structure. Any borrower whose mortgage might be salvaged can be referred to the government program. Servicers will be left only with intractable loans that are unlikely to be paid, including loans to speculators or for investor-owned properties. They might well be better-off selling these loans in bulk to specialists who will have the expertise and incentives to manage troubled real estate. The program of selling troubled loans in bulk through the Resolution Trust Corporation served the country very well in the early 1990s.
Q14: How do you know that house prices have fallen so far relative to rents?

The study (PDF) by Chris Mayer suggests that the credit crunch and rising mortgage rate spreads led the annual cost of owning relative to renting to rise about 15 percent. This pushed down demand for housing and made it less affordable. The study provides details.
Q15: What about the large inventory of existing and vacant homes on the market?

This plan will help encourage new homeowners and the reduction of housing inventory in two important ways. First, by stimulating the housing market and slowing or stopping house price declines, this plan will help new home buyers have confidence in stepping up to purchase a new house. Second, the new mortgage rate of 5.25 percent will lower mortgage payments for new home buyers by about 15 percent, immediately making owner-occupied housing much more affordable. Many other plans are possible to spur housing purchases, such providing a limited-time government match for down payments by new homebuyers. However, these plans require explicit expropriations and raise questions of fairness, and thus are beyond the scope of our current analysis.
Q16: How does this plan relate to the recently passed Housing and Economic Recovery Act of 2008?

Our plan supplements and expands the current legislation in many ways. First, this plan is much broader than the 2008 Housing Act. The Act would produce at most $300 Billion in new credit. Restrictions on who would qualify and stringent losses imposed on lenders make it unlikely that anywhere near that much credit will be injected into the financial and mortgage markets. That plan gives a tax credit of as much as $7,500 that operates as a 15-year interest-free loan to new home buyers. However, because that credit must be claimed on a tax return, it does little to help new home buyers finance their purchase. The housing act does provide for lower down payment loans through the Federal Housing Administration, which will surely help new home buyers.
Q17: Isn’t it unfair to bail out irresponsible homeowners who took on too much leverage?

Clearly some homeowners took on excessive amounts of debt to fund consumption. However, other homeowners took on debt and liabilities that they did not fully understand (see the paper by Brian Bucks and Karen Pence (PDF)). The overarching concern of our proposal is the adverse effect of falling housing prices on the economy. To this end, we propose sharing losses between homeowners, lenders, and taxpayers. Without taxpayer participation, it will be hard to move mortgages out from under servicers and restructure the debt to avoid the continued spiral in housing and the economy. Taxpayers will have to bear some cost of the excesses, as they already have. Doing nothing puts the taxpayers at risk of greater losses on the almost $6 Trillion of existing mortgage guarantees and obligations. This proposal requires borrowers to give up a share of future appreciation in order to participate. Lenders must eat a portion of the losses as well. Everyone gives a little bit.

Q18: How do we derive the calculations of negative equity for owner-occupants?

We use county deeds records from 377 counties in 31 states plus the District of Columbia (AL, AZ, CA, CO, CT, DC, FL, GA, IL, KS, KY, MD, MA, MI, MN, MO, NV, NH, NJ, NM, NY, NC, OH, OK, PA, SC, TN, TX, UT, VA, and WI ) and the 2000 US census. We consider all properties with a sales or refinancing on or after 2000. With rising house prices, a property whose last transaction took place prior to 2000 is unlikely to have negative equity. We identify investor-owned properties as those in which the tax bill is sent to a different address than the property itself. We assume that properties with missing mailing address information are owner occupied. The sample is limited to residential properties described as condominiums, town houses, and single family homes.

From the most recent transaction, we compute an estimated value as of August, 2008 by multiplying the last sale price by the percentage change in house prices in that county based on a county-level price index. Using the history of primary mortgages and additional liens on each property we are able to estimate the mortgage balance on that the property as of August, 2008. To estimate the current outstanding mortgage balance, we use the average fixed mortgage rate during the month of origination (since the actual mortgage rate is not recorded in the deeds records). If the mortgage term length is missing, we assume a term of 30 years. The net equity position for each property is simply the estimated property value minus the estimated debt. We scale the numbers from our sample to national estimates by multiplying our estimates for each variable by the ratio of the number of housing units in the US to the number of housing units in our sample.

Although we are not aware of any other estimates of the total dollar value of negative equity in the US for owner-occupants, our results are roughly comparable to negative equity statistics that we have found from two other sources. Zillow.com estimates that 11.7 million homes have negative equity. These results appeared in a Wall Street Journal article on October 8. First American CoreLogic estimates a total of 7.8 million properties with negative equity. Our estimates place that figure at 10.5 million, 8.8 million of which are owner occupants. Zillow reports that the average amount of negative equity (among households that have negative equity) to be about $59,000. We estimate that the average negative equity for owner occupants (among all owner occupants who have negative equity) is $77,000. As well, using the average negative equity and number of house holds from Zillow we can roughly estimate a national negative equity of $676 billion, where as we estimate total negative equity at $846 billion, $677 billion among owner occupants. Our estimate of the percentage of investor-owned properties is similar to those found by Christopher Mayer, Karen Pence, and Shane Sherlund in their forthcoming article on subprime and Alt-A mortgages in the Journal of Economic Perspectives, available here.