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Rewarding Homeowners for Good Behavior

New Administration Proposals Can Help Families with Congress’s Support

SOURCE: AP/Cliff Owen

President Barack Obama holds up a proposed mortgage application form as he outlines his administration's proposal to allow homeowners with privately held mortgages to take advantage of record low rates for an annual savings of about $3,000 for the average borrower.

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President Barack Obama recently renewed his commitment to struggling homeowners by announcing two major changes to his administration’s foreclosure prevention strategy. If successful, the administration’s plans could make a meaningful dent in the ongoing foreclosure crisis but only with the cooperation of Congress and federal regulators.

President Obama’s first announcement came in last Tuesday’s State of the Union address, when he pledged to give “every responsible homeowner” the chance to refinance his or her mortgage at today’s historically low rates. According to details released yesterday, the new program would help millions of homeowners refinance into new mortgages made by private companies and guaranteed by the Federal Housing Administration, a government-run mortgage insurer. Eligible homeowners must be making timely mortgage payments on the home in which they live and meet other requirements, with a focus on those who are “underwater,” owing more than their home is worth.

President Obama yesterday explained that his plan would help “millions of responsible homeowners who make their payments on time but find themselves trapped under falling home values or wrapped in red tape.” It would not help “the neighbors down the street who bought a house they couldn’t afford then walked away and left a foreclosed home behind,” nor would it benefit those who “bought multiple homes just to speculate and make a quick buck,” he said.

In a different announcement the Treasury Department late Friday unveiled changes to the Home Affordable Modification Program, or HAMP. Since its creation in 2009, HAMP has helped about 900,000 struggling homeowners with private and government-backed loans make their mortgage more affordable by extending terms, lowering the interest rate, or reducing principal. In response to lower-than-expected uptake in its inaugural years, Treasury extended the program’s enrollment deadline, expanded eligibility to more borrowers, and strengthened incentives for servicers and investors to write down mortgage principal.

Together these efforts could help lower monthly housing costs, deleverage household debt, and keep struggling families in their homes, all of which would help our broader economic recovery. But first they’ll have to leap a few massive hurdles.

A closer look at the president’s refinancing plan

If designed well, a mass refinancing program like the one the president proposed has enormous potential to spur economic growth. Three out of four underwater borrowers, or roughly 8 million households, are paying above-market interest rates on their mortgages today according to CoreLogic. Each of these families that are still current on their payments can immediately lower their monthly housing bills by refinancing to mortgages at today’s market rate. But often private lenders will not let them simply because they’re underwater.

The White House estimates the new program will save the average eligible family about $3,000 a year in housing costs, which could in turn be spent on clothes, food, and other consumer goods, spurring new business investments. By comparison that’s three times the expected household benefit from extending the payroll tax cut.

The new program would work alongside existing refinancing initiatives for mortgages guaranteed by the federal government, namely FHA’s Streamlined Refinancing Program and the newly revamped Home Affordable Refinancing Program, or HARP, which helps homeowners refinance loans owned by the government-controlled mortgage giants Fannie Mae and Freddie Mac.

According to the Federal Reserve, between 1 million and 2.5 million homeowners are current on their mortgage payments and meet all the underwriting standards to refinance under HARP but cannot because their loan is not guaranteed by Fannie or Freddie. That’s why the president’s proposed program targets creditworthy borrowers with purely private mortgage loans. In addition the White House yesterday called on Congress to make it easier for homeowners with Fannie and Freddie mortgages to refinance through HARP.

Hurdles to clear

Though promising, the president’s proposal is guaranteed to hit speed bumps.

For starters, the new refinancing program would require congressional approval—no small feat at a time of strong conservative opposition to further government intervention in the housing market. The president also proposed a “Financial Crisis Responsibility Fee” on the nation’s largest financial institutions to cover the program’s estimated $5 billion to $10 billion price tag, ensuring the program does not add to the deficit or draw on FHA’s existing funds.

But it’s unclear whether FHA would need additional congressional authority to collect such a fee. If so, the measure is especially unlikely to pass this Congress, with its particular aversion to new revenue increases.

Second, some critics have argued that any large-scale refinancing initiative will be unpopular among mortgage investors who have been benefiting from holding these above-market-rate assets. But as Moody’s Mark Zandi points out, the expected losses in interest income only “modestly dilute” the overall economic benefit of refinancing. And most of these investors probably should have already been “refinanced out of their investments” by now, Zandi added.

New incentives for lenders to write down mortgage principal

Even if the mass refinancing plan were to pass Congress and win support from investors, it would provide little relief to another major segment of homeowners: those who have just started falling behind on their mortgages. Many borrowers are trying in good faith to keep up with their payments but are too underwater to afford their loan even at today’s interest rates. That’s where HAMP modifications come in.

In reforming HAMP the administration was wise to focus on principal reduction, which many experts recognize as a necessary but missing piece to existing efforts. To avoid future default lenders recognize lost value on the home and structure a better deal with the existing owner so banks and homeowners share losses from the housing collapse. This in turn reduces foreclosures and helps underwater borrowers dig their way out of debt.

Even though one in four borrowers is currently underwater, fewer than 5 percent of permanent HAMP modifications have featured principal reduction. That’s largely because Fannie Mae and Freddie Mac have so far refused to offer principal write-downs as part of their modifications, which cuts out about half of the mortgages in the United States. That makes the Federal Housing Finance Agency, or FHFA—which regulates Fannie and Freddie as their government conservator—a “big boulder in the path to principal reduction,” according to former Obama economic advisor Jared Bernstein.

To defend its position FHFA last week released a report demonstrating its slight preference toward principal forbearance, where a lender temporarily defers payments but maintains the total amount owed on the loan. But the report’s true takeaway is something many have long touted: Principal reduction yields a positive net value to Fannie and Freddie’s books compared to doing nothing.

FHFA’s own analysis found that write-downs for all severely underwater borrowers—those that owe at least 15 percent more on their mortgage than their home is worth—would actually save Fannie and Freddie—and the taxpayers supporting them—about $20 billion over the life of those loans. Indeed, a principal forbearance plan was projected to save Fannie and Freddie slightly more, but FHFA admits that this difference is probably negligible: “Our conclusion was that while forbearance shows a slightly lower loss than [principal reduction], the difference is negligible given the model risk,” the authors wrote.

It’s worth noting that many analysts, including the White House’s Bernstein, have expressed serious concerns over FHFA’s calculations, the details of which were not disclosed in the analysis. But even if you ignore the technical issues, FHFA’s analysis still ignores the long-term benefits of principal reduction compared to forbearance.

Where appropriate, partial write-downs will avoid foreclosures and provide stability to the housing market, which benefits the broader economy and financial system, including Fannie Mae and Freddie Mac. The Federal Reserve in a recent white paper to Congress also described targeted principal reduction as a way to decrease the probability of default, improve migration between labor markets, and make households more resilient to economic shocks.

Similarly, Laurie Goodman of Amherst Securities recently told Congress that principal reduction is “the key to a successful modification” since “negative equity drives defaults.” In a separate report Goodman pointed out that write-downs have much lower redefault rates than other modifications, especially for less risky “prime” mortgages.

The bottom line is clear: Focused principal reduction yields positive results for mortgage lenders. That’s why more than 15 percent of private modifications involved some principal reduction in the third quarter of 2011 according to the Office of the Comptroller of the Currency. Now it’s just a matter of convincing Fannie, Freddie, and FHFA that it’s the best option for them.

There’s a good chance last week’s changes to HAMP could accomplish exactly that. Among other things, the revised HAMP rules extend new incentives to Fannie and Freddie to write down principal. For the first time Fannie, Freddie, and their servicers could get as much as 63 cents on every dollar written off, depending on the riskiness of the loan. It’s unclear whether that’ll be enough to get FHFA on board, but it’s an undeniable step in the right direction.

The administration is wise to focus on commonsense reforms that address the housing overhang slogging our economy. In the coming weeks we’ll see whether Congress and federal regulators will join President Obama and move these proposals forward.

Janneke Ratcliffe and David Abromowitz are Senior Fellows at the Center for American Progress working on housing issues. John Griffith is a Research Associate with the housing team at the Center.

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