Mortgage refinance doesn’t belong in the settlement talks

By Felix Salmon
October 18, 2011
WSJ has the latest mortgage-settlement trial balloon, and it's pretty weak tea.

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The WSJ has the latest mortgage-settlement trial balloon, and it’s pretty weak tea: under the terms of the deal, if (a) you’re underwater on your mortgage, and (b) you’re current on your mortgage payments, and (c) your mortgage is owned by the bank outright, rather than having been securitized, then you would be given the opportunity to refinance your mortgage at prevailing market rates.

It’s worth remembering, at this point, that mortgages are by their nature prepayable. When you write a fixed-rate mortgage, you make a general assumption that if mortgage rates fall substantially, the borrower is going to pay you off and refinance. The underwater questions we’re talking about here were written during the housing boom, when banks simply assumed that house prices always went up; those banks cared massively about prepayment risk at the time, and spent huge amounts of money and effort trying to hedge it.

As it happened, mortgage rates did fall substantially — with the result that the banks’ hedges paid off. But then the banks realized that they could make money on both legs of the deal — that they could collect on their mortgage-rate hedges, without having to worry about prepayment. Because now the borrowers are underwater, they’re not allowed to refinance. So the banks continue to cash above-market mortgage payments every month — something they never expected that they would be able to do.

Naturally, they’re clinging on to this undeserved income stream for dear life:

The refinance program would be particularly costly for banks because they would be forced to give up expected interest income on loans for which borrowers are current on their loan payments and, given their payment histories, unlikely to default. Banks can’t reduce rates on loans they don’t own because the result would be a net loss to the investor.

“Nine months ago this would have been inconceivable,” said one person familiar with the banks’ thinking.

Well no, it’s not inconceivable at all. In fact, wholesale mortgage refinance for underwater borrowers is a major part of Barack Obama’s jobs bill, and the CBO has been costing it in various ways. At heart, it’s a way of rectifying a market failure, and thus makes perfect sense.

But that’s precisely why I don’t think that this plan deserves a place in the mortgage-settlement talks. For one thing, it’s downright unfair and invidious to allow 20% of underwater homeowners to refinance while ignoring the other 80%. More to the point, giving homeowners the ability to refinance their mortgages is what you do, if you’re a bank. It’s not some kind of gruesome punishment.

So let’s keep mortgage-refinance proposals in the arena of public policy, where they belong, and where they can be implemented universally rather than piecemeal. And let’s keep holding the banks’ feet to the fire in the mortgage-settlement talks, and try to get something much more substantive out of them than this.

13 comments

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“At heart, it’s a way of rectifying a market failure, and thus makes perfect sense.”

Very well said, Felix. (I believe I pointed this out last month and was lambasted for the point.) We need to find a way for underwater mortgages to be refinanced in the same way that almost every other mortgage from that era has ALREADY been refinanced due to the lower interest rates.

It is tricky, of course, because nobody wants to write a $400k loan on a $300k property. The economics of that are really bad. The *only* institution that could conceivably do so profitably would be the one that is already on the hook for a $400k loan on that property. (They already are facing significant default risk on the existing loan.) And, of course, it is more profitable for them to collect the higher interest rate.

Here’s an idea — think it might work?
(1) Split the original mortgage into a $300k primary loan and a $100k secondary loan.
(2) Allow the $300k primary loan to be refinanced with a new $300k primary loan at market rates, while retaining seniority.
(3) Leave the $100k secondary loan with the originating bank. (At the original interest rate if you prefer.)

I don’t believe that leaves anybody significantly worse off, does it?

Posted by TFF | Report as abusive

I’d like to know how many (percentage and value) of outstanding loans are represented by part (c) – loans still owned by the bank. I’m going to assume that’s a fairly nominal amount….right?

Posted by rfreeborn | Report as abusive

I’m trying to think through whether TFF’s idea could be implemented even in existing markets, if some bank wanted to get creative… If a homeowner takes out a new loan for some large fraction of the $300k value of their home — say, $240k (or the equivalent of taking a $300k loan and then making a 20% down payment), and uses that money to simply make a huge payment on the $400k loan, they should, in theory, be in a better position to make future payments, right?

The problem, of course, is the question of whether the new creditor or the old one has the senior claim in the event that the homeowner ultimately defaults on one or both loans. If the old creditor retains the senior claim, then the new creditor will not be willing to offer the super-low prevailing market rate.

What we need is a law that says that underwater homeowners have a right to re-fi into a loan that appropriately values their home, and that while the existing senior mortgage creditor should be given the first right to offer such a re-fi, if they refuse to do so, then we’re cramming them down and giving the senior position to somebody more reasonable.

Posted by Auros | Report as abusive

All readers are missing the point and the real solution. The US home mortgage issue is a 12-15 $ Trillion issue. To stablize value, prices of real estate needs go no lower. If values continue to fall it benefits no one and hurts everyone in every country that believes in private ownership of real estate. I have presented a plan to the speaker of the US House of representatives that will spur the economy and jobs while putting the entire cost of the plan on the banking system and not government tax payers.

Using a combination US Treasury Zero Coupon Bonds, Federal Reserve Discount window access and other tweeks, all current mortgages could be saved and upto $6 Trillion available to banks to lend to get the worlds economy back on tract and several organizations like Freddie and Fanny will be put out of business.

Posted by edward.gre | Report as abusive

Auros, unless I’m forgetting something…

* The homeowner would reduce payments in the refi, principally by bringing the mortgage rate down for the majority of the loan.

* The new lender might be a little reluctant to participate in a property that is underwater, even if granted senior position on an 80% LTV segment, since the foreclosure risk on such properties is definitely elevated. However the governmental guarantees required to grease the skids ought not be TOO expensive. The nice thing about 80% LTV mortgages is that recoveries are fairly high, even in the event of a default.

* The old lender is slightly better off. They are guaranteed full repayment of the refinanced portion and a reduced risk of default on the remaining portion. In the event of a default that entire remaining portion will be wiped out — but that is still better than what would have happened before the prepayment.

Such a program would definitely require tinkering with rights of seniority, however I believe that can be executed voluntarily even under current law? So all that really remains is a program to codify and manage the transaction, and to guarantee the new 80% LTV loan.

Posted by TFF | Report as abusive

I have never missed a payment on my 2006 originated loan. I’m at 6% and 25% underwater. The problem is that I signed up for those terms of my own free will. Any program which allows me terms better than someone making a purchace transaction can achive is a transfer of wealth from others to me.

Posted by y2kurtus | Report as abusive

y2kurtus, my proposal as outlined above would not give you terms better than someone making a purchase transaction. It would simply allow you an opportunity to refinance most of that 6% loan at a lower rate.

It isn’t exactly debt relief — you would still owe the money. It is more-or-less within the terms of the original agreement, which allows prepayment of principal.

Yes, it is in some sense a transfer of wealth (since the current terms trap you into what is now an unfavorable agreement), but it is a transfer that comes very close to operating within the parameters of the original agreement. Might work with all parties freely cooperating, and minimal push/support from the government? Isn’t that the best kind of agreement?

Posted by TFF | Report as abusive

@TFF, that sounds like a pretty reasonable idea.

@y2kurtus, what exactly would you be getting that a person currently buying a similar $400,000 house could not get? A new purchaser could finance the entire loan at the lower prevailing rate, correct? What am I missing?

Posted by spectre855 | Report as abusive

“And let’s keep holding the banks’ feet to the fire in the mortgage-settlement talks, and try to get something much more substantive out of them than this.”

No, let’s abandon (as the relatively sensible parties already have) the settlement talks entirely. The talks are a farce. The banks shouldn’t be settled with. The banks should be thoroughly investigated and then sued for everything they have. And the crooks thrown in jail.

Posted by Moopheus | Report as abusive

I do agree to just keep mortgage-refinance proposals in public policy because yeah, that’s where they belong. But I also stress that banks should also be investigated for any anomaly. How do i get out of debt?

Posted by brokemf | Report as abusive

I do agree to just keep mortgage-refinance proposals in public policy because yeah, that’s where they belong. But I also stress that banks should also be investigated for any anomaly. How do i get out of debt? http://brokemf.com

Posted by brokemf | Report as abusive

we are almost 300% underwater in our mortgage, we are current on our payments and we both work and have no promblem making payments. BUT the city just did reconstruction on the ditches and roads and now our front yard is under water literally! we just bought new windows last year and we are not sure if we can walk away, shortsale???

Posted by sands1998 | Report as abusive

we are almost 300% underwater in our mortgage, we are current on our payments and we both work and have no promblem making payments. BUT the city just did reconstruction on the ditches and roads and now our front yard is under water literally! we just bought new windows last year and we are not sure if we can walk away, shortsale???

Posted by sands1998 | Report as abusive