In favor of wholesale mortgage refinance

By Felix Salmon
September 8, 2011
David Wessel and Shahien Nasiripour have similar reactions to the CBO paper on the costs and benefits of a wholesale mortgage refinance.

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David Wessel and Shahien Nasiripour have similar reactions to the CBO paper on the costs and benefits of a wholesale mortgage refinance. Both of them say the effect of such a scheme would be pretty small, especially when you take into account the fact that the government would lose $4.5 billion, and private investors another $13-15 billion, in prepayment losses. Here’s Shahien:

Some 2.9m mortgages worth $428bn would be refinanced, saving borrowers $7.4bn from lower payments and averting 111,000 defaults at a cost of about $600m to the US government, the CBO said.

But investors in mortgage-backed securities guaranteed by the US would lose about $13bn to $15bn from prepayments on securities yielding above-market rates, the economists say.

This is all true — but I think it overstates the costs and understates the benefits of this idea.

For one thing, the benefits side can easily be increased just by tweaking a few numbers. The CBO paper just says that the new, refinanced mortgages would be issued at the “prevailing market rate”, without saying what that rate is; I think they’re using a rate around 4.5% on a 30-year fixed mortgage. But agency paper is trading at much lower yields than that. If you refinance existing mortgage holders at a rate of say 3.5%, then you’ll get many more people participating, and everybody participating will save a lot more money.

What’s more, the benefits side of the CBO calculation includes the mortgage-interest savings only for the first year — as are the savings to the GSEs of having to pay out less money in guarantee obligations. But the idea here is to refinance into 30-year bonds, so the total savings are much bigger, over the course of ten or 30 years, than the numbers in the CBO paper.

Meanwhile, the big prepayment “losses” are wholly a one-off expense which will never be repeated; it’s a bit disingenuous to take one year’s annual savings, as the CBO does, and then subtract a big one-off cost in order to get a net cost to the federal government of $600 million. Why not take two years’ savings, or three, or ten?

But what are these prepayment losses, anyway? They’re calculated by taking the market value of the mortgage-backed securities backed by the mortgages which will be refinanced, and then assuming that those securities will be paid off at 100 cents on the dollar. Since the securities are trading well above par right now, around 106 cents on the dollar, anybody who marks to market would suffer a loss of about 6% on their holding.

Let me translate that into English for you: the CBO is saying that if we paid off current bondholders at 100 cents on the dollar, they would lose as much as $15 billion. Doing so is entirely legal and proper: all of these mortgages can be prepaid. And anybody buying a mortgage bond cares first and foremost about prepayment risk — this would hardly come out of the blue.

But what’s happening right now is that mortgage bonds are trading well above par just because investors are well aware that refis are hard to come by for many homeowners. They’re basically taking unfair advantage of the fact that homeowners are locked into above-market mortgage rates. If the value of their bonds came down towards the face value of the bonds, that would be a good thing. It’s not good when mortgage bonds trade well below par, but it’s not good when they trade well above par, either — it’s a sign of market failure. Remember, there would be no default involved here. So bondholders really couldn’t complain much.

One of the ways that capital takes advantage of labor in this country is the way in which homeowners who can prepay their mortgage for free often don’t take advantage of that option even when it’s available to them and doing so would save them tens of thousands of dollars. I think there are psychological reasons for this, but any plan which reduces the ranks of those homeowners is a good idea in my book.

Besides, it’s about time that homeowners who have diligently been paying off their mortgage, in full, throughout the financial crisis and all the way to the present day, should get some kind of reward from the government. This idea is a much better way of doing that than is the dreadful and hugely expensive institution of mortgage-interest tax relief. What we need, right now, is for the US as a whole to take advantage of the incredibly low interest-rate environment. Wholesale mortgage refinance is a great way of achieving exactly that goal.

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