Paper Suggests Lower GSE Fees May Pay Off in Reduced Defaults

The Federal Reserve Bank of New York
recently released a paper that looked at the impact of HARP revisions on loan
defaults and pricing
.  The paper, Payment Changes and Default Risk: the Impact
of Refinancing on Expected Credit Losses
was written by Joseph Tracy and
Joshua Wright. 

When the Home Affordable Refinance Program
(HARP) was initiated, its goal to stimulate the economy and reducing defaults
by lowering mortgage payments in households with high loan-to-value mortgages. These
were borrowers who were otherwise unable to refinance.

HARP was implemented in 2009 but refinancing
activity was much lower than expected. 
Just over one million refinances have been done under HARP rather than
the 3 to 4 million expected.  This
confirms, the authors say, the original rationale for HARP, that in the wake of
the housing bust borrowers need help refinancing.

HARPS lackluster results have provoked discussion
about the impediments to refinancing including credit risk fees, limited lender
capacity, a costly and time consuming appraisal process, limitations on
marketing, and legal risks for lenders.  HARP
was recently revised to better address these impediments. .

Concerns about revising HARP included
doubts about its fairness and about macroeconomic efficiency.  The Federal Housing Finance Agency (FHFA) has
a responsibility to weigh the value of any proposed changes in terms of a possible
impact on the capital of the government sponsored enterprises (GSEs).  These could include a reduction in the income
generated through interest on the GSE’s Holdings of MBS, on the expected
revenues from the put-backs of guaranteed mortgages that default, and finally
on the impact of refinancing on expected credit losses to the GSE fees. 

One outcome of an improved program would
be more borrowers in a position to refinance. 
Estimates can be made of the average reduction in monthly mortgage
payments that would result from a refinance; the question is how this payment
reduction would affect future defaults. 
Ideally a study could determine the difference in expected credit losses
from two identical borrowers with identical mortgages where one borrower
refinances and the other does not.  However,
once the existing mortgage is refinanced it disappears so both
mortgage/borrower sets cannot be similarly tracked and the impact of the
payment change on a borrower’s performance must be inferred.

A recent congressional budget office
working paper estimates that reduced credit losses would produce an incremental
2.9 million refinances of agency and FHA mortgages and that such a program
would reduce expected foreclosures by 111,000 or 38 per 1000 refinances,
reducing credit losses by $3.9 billion.

Using data from Lender Processing
Services the authors selected eligible borrowers from among borrowers who had
been current on mortgage payments for at least 12 months and had estimated loan-to-value
ratios (LTV) over 80 percent. To measure motivation the authors selected loans
where the borrower could recover refinancing costs in two years.  Using these parameters it was determined that
refinancing would reduce the required monthly payment by 26 percent on average.

The authors found impacts on results
from various combinations of local factors such as house prices, employment
rates, the local legal methods of handling delinquencies, and contagion risk,
i.e. the exposure of the borrower to others who had defaulted.  There were also effects from FICO scores and
debt to income ratios and loan specific factors such as the purpose of the
loan, full documentation of the loan, and length of loan term.  Various methods were used to control for
these variables including excluding loans from the sample.

It is acknowledged that LTV ratios have
a significant correlation with default and the authors did test and confirm
this relationship.   The next step was to estimate the impact of a
26 percent payment reduction on the average default rate.  The authors used estimated ARM default and
prepayment hazards to do a five-year cumulative default forecast holding the
local employment rate and home prices stable. 
At five years the models imply that the expected cumulative default rate
would be 17.3 percent. When the payments are reduced by 26 percent the expected
default rate is reduced to 13 percent a 24.8 percent reduction.   The same analysis was run for borrowers with
prime conforming fixed-rate mortgages obtaining a cumulative default rate of
15.2 percent which refinancing reduced to 11.4 percent, a decline of 3.8
percentage points. 

These figures were used to conduct a
simple pricing exercise to measure the difference between a refinancing fee
that maximizes fee income for a certain category of borrowers and a fee that
maximizes the combination of the fee income and the reduction in the expected
future credit losses using the GSE pricing categories for their loan level adjustments.  It was found that FICO score strongly impacted
both payment reductions and default rates ultimately resulting in reductions in
the default rate of 1.9 percentage points for a high FICO borrower and 9.1
points for a low one.  This implies that
incorporating the impact of expected credit losses into the pricing decision
should generate higher price discounts for weaker credit borrowers as measured
by FICO score and LTV.

The authors found that incorporating the
impact of expected credit losses after refinancing on average lowed the desired
pricing by 17 basis points.  Looking at
the averages by LTV intervals shows an impact of 15 basis points for mortgages
with a current LTV of 80 to 85 and increases to 14 basis points for mortgages
with a current LTV of 105 or higher. 
Basing fees on FICO scores involves a much more complicated set of
factors. 

The authors conclude that the average
HARP refinance would result in an estimated 3.8 percent lower default
rate.  Assuming a conservative average
loss-given default of 35.2 this indicates an expected reduction in future
credit losses of 134 basis points of a refinanced loan’s balance.

The paper concludes that the impact
of refinancing on future default risk is important to the current debate of the
GSE fee structure for HARP loans.  “These
results suggest that refinancing can be fruitfully employed as a tool for loss
mitigation by investors and lenders.  The
optimal refinance fee will be lower if this reduction in credit losses is
recognized.”  Reducing fees, the authors
say, will increase incentives to refinance but at the cost of fee income to the
GSEs.  “Our analysis shows, however, that
there is an offset to this lower fee income today which is lower credit losses
in the future.”

…(read more)

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Fed Report: Mortgage Mess NOT an Inside Job

A paper just published by The Federal Reserve Bank of Boston is bound to generate a lot of comment both inside and outside of the mortgage industry.  Titled Why Did so Many People Make so Many Ex Post Bad Decisions?  The Causes of the Foreclosure Crisis, the paper presents 12 facts about the mortgage market which the authors say refute the conventional wisdom that the housing crisis resulted from financial industry insiders deceiving uninformed borrowers and investors.

The authors, Christopher L. Foote and Paul S. Willen, senior economists at the Boston Fed and Kristopher S. Gerardi , a research economist at the Federal Reserve Bank of Atlanta, argue that borrowers and investors made decisions leading up to the crash that were rational and logical given their ex post overly optimistic beliefs about house prices and that neither institutional features of the mortgage market nor financial innovations are likely to explain those distorted beliefs.  “Economists should acknowledge the limits of our understanding of asset price bubbles and design policies accordingly.”

There are two general explanations for the mortgage crisis.  The insider/outsider explanation, the most dominant one, is that well-informed mortgage insiders used the securitization process to take advantage of uninformed outsiders.  This story paints a mortgage broker convincing a borrower to take out a mortgage that initially appears affordable but with an interest rate wired to explode a few years later, throwing the clueless borrower into default.  The mortgage broker does not care about the risks because he is passing the mortgage on to an investment banker who then includes it in a mortgage-backed security.  The banker intentionally uses excessively complex financial engineering to dupe the investor about his investment.  When the loan explodes the borrower loses his home and the investor loses his money but the broker and the banker have no skin in the game and thus suffer no losses.

The second theory does not draw a line between insiders and outsiders but depicts a “bubble fever” infecting both.  If each believes that house prices will continue to rise rapidly then it is not surprising to find borrowers stretching to buy the biggest house they can and investors lining up to give them money.  Rising house prices generate capital gains and insulate investors against losses.  If this alternative theory is true then securitization was not the cause of the problem it merely facilitated transactions that borrowers and investors wanted to undertake anyway.

The authors lay out 12 “facts’ about the mortgage crisis

…(read more)

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Letter to Cordray Requests Industry Input into Qualified Mortgage

Thirty-three housing related organizations have signed on to a letter advocating that a broadly defined definition of a Qualified Mortgage (QM) be attached to the forthcoming Ability to Pay regulation being formulated by the Consumer Financial Protection Bureau (CFPB).  The letter, sent today to Richard Cordray, Director of the Bureau, urged the Bureau to avoid an unnecessarily narrow definition of QM that will cover only a “modest proportion loan products and underwriting standards and serve only a small proportion of borrowers.”  This, the letter states, would undermine prospects for a housing recovery and threaten the redevelopment of a sound mortgage market.

The letter was signed by the leading trade associations in the industry including the American Bankers Association, National Association of Realtors, and Mortgage Bankers Association, but also by consumer groups such as Habitat for Humanity, the National Council of State Housing Agencies, and lesser known organizations like the Center for NYC Neighborhoods, Community Associations Institute, and the National Association of Hispanic Real estate Professionals. 

The letter said that while the groups hold different views about whether the QM should be designed as a safe harbor or a rebuttable presumption they are united in urging the CFPB to construct a broadly defined QM using clear standards to help the economy and to ensure that the broadest universe of credit-worthy borrowers are able to obtain safe loan products for all housing types.

Every version of financial reform paired the Ability to Repay provisions with the QM, including the final version of the Dodd-Frank Wall Street Reform Act.  The reasoning, according to the letter’s authors was that pairing the prospect of liability with an exception for well underwritten more sustainable laws was the best way to ensure sound lending.

The law also includes lender liability for steering borrowers to non-QM loans and gives the Bureau leeway to definite QM in a way that will ensure that safe and responsible mortgage credit remains available to borrowers.  Taken together these provisions demonstrate that Congress intended that all creditworthy borrowers, especially low and moderate income borrowers and persons of color should be extended the protections of a QM.

The writers contend that defining QM too narrowly would throw many of today’s loans and borrowers into the non-QM markets, putting lenders and investors at a high risk of an Ability to Pay violation and even a steering violation.  As a result, these loans are unlikely to be made and if they are they will be far costlier, burdening those families least able to bear the expense.  In addition, these higher priced loans would not be exempt from including important protections against the very practices and loan features that drove the highest failures in the mortgage boom, features that are embedded in the QM

The writers say that they support the strong regulatory standards to ensure that earlier mistakes are not repeated and believe that QM is central to that effort but, rather than narrowing the market, “creating a broad QM which includes sound underwriting requirements, excludes risky loan features and gives lenders and investors reasonable protection   against undue litigation risk, will help ensure revival of the home lending market.”

The letter concludes with a request to include representatives from the groups signing the letter in meetings with Bureau staff to “discuss all of these concerns and to share our data.”

…(read more)

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Crime (Writing) Pays: Authors’ Desert Retreat

Best-selling novelists Jonathan and Faye Kellerman write at their four-building compound outside Santa Fe, N.M.

Crime (Writing) Pays: Authors’ Desert Retreat

Best-selling novelists Jonathan and Faye Kellerman write at their four-building compound outside Santa Fe, N.M.