U.S. May Back Refinance Plan for Mortgages

First Reported: August 24, 2011

Late last week, the New York Times reported that the Obama administration is considering a plan to “allow millions of homeowners with government-backed mortgages to refinance them at today’s lower interest rates, about 4 percent.” That would mean up to $85 billion in stimulus a year, significant relief for many homeowners who are struggling to make their payments, and the beginning of a new effort to address the troubled housing market. It’s also an idea with a significant expert pedigree: It’s been endorsed by such disparate thinkers as Berkeley’s Brad DeLong, the Peterson Institute’s Joe Gagnon and Glenn Hubbard, ex-chair of George W. Bush’s Council of Economic Advisers. So it should happen, right?

Sadly, no. My efforts to confirm the story have been pretty fruitless. I don’t think the chances of a major new refinancing policy are very good . First, you have to ask how it would pass — and no, the Obama administration couldn't simply wave its wand. Second, you have to answer some thorny policy questions that have bedeviled the administration’s previous housing efforts, and basically boil down to whether taxpayers are willing to subsidize housing debt.

Passing the plan is probably the toughest challenge. Most people think that the Obama administration “owns” Fannie Mae and Freddie Mac, and so it can basically tell them to do whatever it wants. That’s not how it works. The Housing and Economic Recovery Act of 2008 put Fannie Mae and Freddie Mac under the control of the newly created Federal Housing and Finance Authority.

The FHFA is not like, say, the Treasury Department. It’s an independent agency, and right now it’s under the care of acting Director Edward DeMarco, a holdover from the Bush administration. Senate Republicans blocked the Obama administration’s nominee, Joe Smith, after he expressed some support for using Fannie Mae and Freddie Mac to heal the housing market. Any plan would either need to go through him or through Congress. And both DeMarco and the Republicans in Congress seem mostly interested in limiting Fannie and Freddie’s short-term losses so they can be spun off from the government.

But let’s say it passed. The next big issue is known as “reps and warrants.” The short way of explaining this is that when the banks hand a loan over to Fannie and Freddie, they basically swear that the loan was properly constructed. If that later proves untrue, Fannie and Freddie can force the bank to buy it back. This happens a lot, and the option is worth billions to the mortgage giants. When banks refinance a mortgage, they basically take on the risk that the mortgage wasn’t constructed right in the first place. In a refinancing situation — particularly a refinancing situation where you’re dealing with homeowners who might default — they don’t usually want that risk. So either Fannie Mae and Freddie Mac eat billions by giving up their ability to challenge these reps and warrants, which they could do if the FHFA/Congress wanted them to, or the banks won’t refinance these loans and the program will be a bust.

There’s a similar, though less complex, problem the costs associated with refinancing a mortgage. When you add up loan-level adjustment costs, title insurance, reappraisal, and all the rest of it, it’s often more than an underwater homeowner can bear. You can solve this problem the same way you can solve the rents and warrants problem — either make the banks eat the costs, in which case they may not participate, or get the government to eat the costs — but you’ve got to figure it out.

You’ll notice that I’ve been talking mostly about underwater homeowners here. Though this policy would theoretically affect everyone, the reality is that creditworthy borrowers who aren’t underwater on their homes can refinance at very low rates right now. They don’t need this policy. It’s possible that this would create an announcement effect that would make more of them aware of the opportunity and thus lead to higher take-up, but the guts of this change would really be about making it easier for underwater homeowners to refinance.

But the administration has tried and failed at that before. The HARP program, for instance, theoretically allows Fannie Mae and Freddie Mac to refinance homeowners who are up to 25 percent underwater on their mortgages. It’s just not worked very well, in part because it never solved these issues. For refinancing to work, Fannie Mae and Freddie Mac need to be willing to increase their exposure to losses. As of yet, the FHFA has been unwilling to do that, and the administration hasn’t been able to roll them — though some people argue they simply haven’t tried hard enough.

Which isn’t to say it shouldn’t be tried. Quite the opposite, actually. The best of all possible worlds would be for DeMarco to give the go-ahead and for the government to eat at least some of the losses on refinancing costs and reps and warrants. But DeMarco seems unlikely to do that, Congress is even less likely to overrule him, and so the likeliest outcome seems to be something between nothing and a diluted refinancing initiative that does much less than advocates hope and homeowners need.

By Ezra Klein  |  03:20 PM ET, 08/25/2011

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