Interest Rate Roundup

Thursday, February 21, 2008

An intriguing OTS idea to combat the "upside down" problem

I haven't been fond of some of the mortgage bailout/reform proposals that have been put forward. In particular, I don't like the idea of increasing the loan limits for Fannie, Freddie, and the FHA. This is happening in many geographic regions thanks to provisions contained in the economic stimulus package.

Why? Well, Fannie and Freddie have clearly seen losses and delinquencies rise as a result of the housing bust. Delinquency rates have also risen on FHA loans. But the damage has been milder than what we have seen at many private lenders. That's because Fannie and Freddie didn't/couldn't participate in some of the riskiest parts of the mortgage market. Meanwhile, FHA lost market share to private lenders willing to expose themselves to much higher risk. Many of those private lenders are now going bust or cutting back dramatically.

In short, high-risk mortgage lending proved to be a stupid gamble. Private lenders took it, and they're now paying the price for it (as they should in a capitalist economy). So why on earth would we want the GSEs and FHA to make the same mistake -- namely, go further out on the mortgage risk curve? That will only mean THEY suffer the biggest share of losses in the next downturn.

But yesterday brought some surprisingly fresh thinking from the Office of Thrift Supervision. Specifically, the OTS floated an interesting plan to keep upside-down borrowers from abandoning their homes. It would allow those who owe more than their houses are worth to refinance into new loans equal to the CURRENT value of their homes.

The original lender would get part of his original loan paid off. He would also get a "negative equity certificate" equal to the difference between the current value and the original loan balance. The lender could redeem that certificate later on if the value of the house were to rise between the time of the refinance and the time the house was eventually sold.

Confused? This CNNMoney report uses an example to clear things up:

"If a house has a $100,000 mortgage originally," said Bill Ruberry, a press spokesman for the agency, "and the fair market value is $80,000, there's $20,000 in negative equity. The lender could refinance for $80,000 and a warrant [for the $20,000 in lost value]."

If the house later sold for $100,000, the lender would collect the $80,000 mortgage balance plus the $20,000. If the sale realized more than $100,000, the certificate holder might even get interest on top of the $20,000. Any profit beyond that would go to the borrower. The warrants could be publicly traded."

Reuters says Treasury is studying the idea. There's no way to tell if or when something will be put into practice. But it seems like a win for everyone involved.

* Borrowers who want to stay in their homes, but are having trouble making payments on large mortgages and are growing hopeless because they are so upside-down, get to refinance into smaller mortgages equal to the current value of their homes. This "rewards" those willing to stick around and tough out the downturn, and potentially lowers the amount of foreclosures the country would otherwise face.

* Lenders are forced to take a hit on their existing loans, hopefully eliminating the "moral hazard/bailout" problem. But they are given something in return for their willingness to work with their borrowers -- "call options" on the future values of the underlying homes.

* Lastly, the FHA gets smaller loans that leave the underlying borrowers paying a smaller chunk of their incomes on debt service (because the principal amounts being financed would be lower on the new loans than the old loans). Such loans would be more likely to perform over time.

I would even consider going a step further -- capping the new loans at 95% of the current value of the homes in question, with the additional 5% rolled into the negative equity certificate balances. That way, the lenders take bigger penalty hits and FHA gets a bit more cushion built into the bargain.

Drawbacks? Well, a purely market-based solution to this housing mess is best. If we just let home prices fall to levels where average borrowers with typical paychecks can afford to buy homes using traditional mortgages, then true, "natural" demand for housing will return. We'll end up with a healthier housing market over the longer term.

Also, it's likely that home values will continue to fall over the next year or two no matter what the government does, intervention-wise. That means FHA could end up getting a 100% LTV loan today that ends up as a 105% or 110% LTV loan down the road. Result: The borrower defaults anyway, and FHA gets stuck with the loss ... while the original private lender just tears up his call option contract.

And let's be honest -- many homeowners are at a point where they won't even answer their lenders' phone calls. Lots of them will walk away no matter what their lenders are willing to offer. Still, kudos is due to the OTS for some innovative thinking at a time when many bailout proposals are simply misguided or unwise.


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