CBO Evaluates Potential Costs of a Large-Scale Refinancing Program

The
non-partisan Congressional Budget Office (CBO) just released a working paper
entitled An Evaluation of Large-Scale Mortgage
Refinancing Programs
in which it analyzed a large-scale program that would
relax current income and loan-to-value restrictions for borrowers who wish to
refinance mortgages currently held by Fannie Mae, Freddie Mac, or the Federal
Housing Administration. The analysis uses an estimate of the increased
refinancing that would occur and how future default and prepayment behavior
would be affected by such refinancing.   

The paper was written by Mitchell Remy and
Damien Moore, both of the Financial Analysis Division of the CBO and Deborah
Lucas, Sloan School of Management at the Massachusetts Institute of Technology.

Despite
the gradually recovering economy, the paper says, the housing market remains
weak and, in addition to the large number of mortgage delinquencies and
defaults many homeowners are unable to refinance and take advantage of record
low interest rates
.  This has prompted a
number of proposals for federal programs to provide opportunities for refinancing
which would free up household income for non-housing expenditures as well as
help some homeowners avoid future default.

The
lack of refinancing is driven by weakened household balance sheets that make it
difficult for some borrowers to meet debt-to-income (DTI) ratios; other
homeowners find their equity eroded by falling house prices and cannot qualify
for refinancing based on the loan-to-value (LTV) ratios of their homes.  The increased stringency of underwriting
requirements on the part of the government sponsored enterprises (GSEs) and FHA
have also contributed to the inability of others to qualify for refinancing. 

The
government has launched several efforts to assist such homeowners but program
features and eligibility criteria have excluded a significant number of
homeowners who might have benefited. 
These efforts have also been restricted to homeowners with mortgages
insured by the GSEs or other Federal programs representing 56 percent of all
outstanding loans.

But,
while mass refinancing of these loans might save the government some eventual
losses because of future defaults, mortgage investors would experience losses
through loans that are prepaid more quickly than without such programs.  Many of these losses would hit taxpayers
through mortgage-backed securities held by the Federal Reserve, the GSEs and
the Treasury.  The stylized refinancing program
studied by the authors would increase the availability of refinancing and
slightly lower its cost. 

Homeowners
are generally free to refinance at will, weighing positive factors such as a
lower rate or better terms against the financial costs of refinancing such as
appraisal costs, settlement fees, and the time and effort involved in the
process.  That freedom, however, comes at
a cost as investors evaluate prepayment risk and factor that into the price of
their loans.

Over
the years refinancing has periodically affected large percentages of the
outstanding mortgage debt, particularly in periods of declining rates and several
changes in the market such as automated underwriting and property-valuation
models, the widespread use of credit scores, auto have increased the likelihood
homeowners will refinance. 

However,
unlike similar periods of declining rates, the fact that rates have dropped
more than 1.5 percentage points since 2007 has not sparked a refinancing
wave.  This is largely due to the
financial crisis.  First, a significant
number of mortgages were actually originated during this period of
extraordinarily low rates and earlier transactions have more or less drained
the refinancing pool.  Then there are the
widely acknowledged impediments to refinancing the remaining high interest
loans – home price declines, reduced income or unemployment, continued high
levels of consumer debt, and significantly higher underwriting standards.  Many loan products such as interest only, no
documentation, and negatively amortizing loans have been curtailed or have
disappeared.

These
impediments to refinancing are reflected in the unusually high premium over
face value that investors are willing to pay for MBS with high coupon
rates.  The possibility of prepayment
usually prevents MBS from rising in price much above par value but the current
pricing indicates that investors expect these impediments to last and thus
their investment to continue considerably longer than usual.  In January of 2011, weekly pricing for
premium ($100 par) Fannie Mae 30-year FRM ranged from just below $105 to
considerably over $107.  The authors say
that, while many factors influence MBS pricing “a strong case can be made for
lower prepayment expectations as an important component in the price premium
investors are currently willing to pay for those securities.”

The
authors examined the parameters and criteria of existing refinancing programs
such as the GSE’s Home Affordable Refinance Program (HARP) and some programs
proposed under pending legislation before laying out their design
considerations for a stylized large-scale program.  These include whether to include only GSE
guaranteed mortgages or those guaranteed by FHA and private-label mortgages as
well.  Should only borrowers who are
current on their existing loans be allowed to participate, only those who are
delinquent, or both?  Should guarantee
fees be increased to reduce the federal cost of the program even if it reduced
the potential pool of borrowers or should the fees be reduced to generate the
opposite effect?  The degree to which
underwriting procedures are waived or fees are waived or subsidized could
significantly affect participating rates but could result in loans that are
less appealing to investors and thus increase the interest rate on the
loans.   

A
final consideration, they said, is the degree to which the LTV is
utilized.  Limiting the level of negative
equity may mitigate the severity of the loss in the case of default, a risk
that the guarantor already carries and hopes to reduce through granting a lower
monthly cost.  Another question is
whether a current LTV is required.  Waiving
an appraisal would save the borrower a fee but would deny investors an
up-to-date assessment of the potential risk of default inherent in the loan.

The
stylized program that emerged from these considerations had the following
characteristics:

  • It
    would start in the first quarter of 2012 and be available for one year.
  • Eligible
    loans would be existing mortgages guaranteed by the GSEs or FHA.
  • The
    borrow must be current and never more than 30 days late on the existing
    mortgage during the prior year but there are no limits on the borrowers current
    income or on the LTV of the new loan.
  • The
    GSEs and FHA will assess a guarantee fee equal to that charged initially on the
    existing loan. This will be incorporated
    into the interest rate by the GSEs and charged as an annual premium by FHA.
  • The
    loan will have a fixed rate of interest at the prevailing rate and a 30 year term.
  • Lenders
    and third party fees will be the lesser of 1 percent or $1000 to process the
    loan.

The
authors estimate that the potential target audience for the program is
borrowers with mortgages in existing MBS with outstanding balances of $4.3
trillion as of June 1.  Of that total,
the GSEs guarantee $3.5 trillion.  These
are all fixed rate mortgages.  Although
borrowers with adjustable rate mortgages (ARM) would also benefit from the
program they, as well as non-traditional and delinquent borrowers were excluded
from the analysis to eliminate certain complexities in estimating incentives.

Borrowers
were classified by the interest rate on their current mortgage, the term, and risk
characteristics that affect their propensity to default on their mortgages.  The groups were further characterized by the
borrower FICO score, the mark-to-market LTV on their existing mortgage and its
origination year and the imputed interest rate on a new mortgage.  This resulted in classification into 108
distinct groups representing the combination of two maturities, nine coupon
rate pools, and three risk categories. 
Total program costs are the sum of the cost per dollar of outstanding
loans multiplied by the estimated total principal balances across each of the
108 groups.

Each group was run through a
model to simulate a scenario and determine the incremental refinancing
attributable to the program and a base case scenario to estimate expected repayments,
defaults, and loss severities over each group without the program.  The analysis then presumed that all borrowers
had an LTV of 50 percent, FICO scores of 780, and assumed the new mortgage had
a rate reflecting market conditions and discounted transaction fees.

The difference in prepayment
volumes between the base case and the program model represent the incremental
refinancing attributed to the program over the course of calendar year 2012 and
those rates, applied to estimated outstanding principle balances, determine the
expect dollar volume of the incremental financing.

The
relaxed underwriting constraints result in identical refinance rates between
high, medium and low risk categories with the same MBS coupon in the program
scenario.  Borrowers in the high and
middle risk categories (higher LTV, lower FICO) benefit the most from the
program based on the increase in refinance rates between the base case and
program scenarios.  Because these groups
are a small portion of the borrower population, however, the greatest number of
incremental loans is expected in the low risk group where borrowers are likely
to be attracted by the lower costs of the program.

A
program such as that analyzed offers benefits to homeowners including lower monthly
payments resulting from lower interest payments and lower principal payments because
of the re-amortization of the loan.  This
results in an increase in disposable income which could help the economy,
assist the borrower in paying down other debt, and in some cases help prevent eventual
default. 

The
authors estimate that the program would result in incremental refinancing of
2.9 million mortgages with first year gross cash savings from reduced mortgage
payments of roughly $2,600 per borrower or a total of $7.4 billion.

The
model predicts that approximately 111,000 fewer loans will default as a result
of this program, in comparison to the approximate 4 million borrowers currently
past due on their mortgages.

The
results have cost implications for the GSEs, FHA, the Federal Reserve, and the
Treasury Department.  Because of their
mix of credit guarantees and portfolio investments the GSEs will experience
both gains and losses; FHA will see gains from credit guarantees and the Fed
and Treasury will face losses through their investments in MBS.  Total federal losses from investment will be
4.5 billion resulting in a net federal loss from the program of $0.6 billion.

Non-government
investors hold 65 percent of the outstanding MBS included in the analysis and
also held a greater share of older, higher coupon securities than the Federal share.  Non-federal investors were expected to suffer
a fair-value loss of $13 to $15 billion, triple the federal loss.

The
authors see several impediments to program implementation.  One is the possible inability or
unwillingness of lenders to scale up quickly to meet program demand, especially
in light of the low origination volumes in recent years.  A second obstacle is the willingness of
subordinate lien holders to make the financial or operational considerations
necessary to facilitate refinancing the first mortgage and private mortgage
insurers must agree to the terms of the refinancing if insurance will be
needed.  The authors assume that the
potential of reducing default may be attractive enough to convince these third
parties to participate.  If this is not
correct the number of participants in the program may be reduced
significantly.  Finally, the program
could be imperiled by rising interest rates during the program and could be
affected either positively or negatively by the direction of housing prices
which, if rising, may allow more homeowners to qualify for this or other programs
and if falling may lessen the numbers who are eligible or drive more borrowers
into default.

Article source: http://www.mortgagenewsdaily.com/09082011_refinancing.asp

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