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The good, bad, ugly on the mortgage plan


Comment by Mike Larson, Real Estate Analyst with Weiss Research
The good, the bad, and the ugly on the mortgage plan - Feb 20, 2009

The mortgage plan has been made public. The questions going forward are simple: Will this latest plan work? And what are its biggest flaws?

Let's start with the "good":

First, mortgage lenders and investors appear to be taking the "first hit" on whatever modification would get a borrower's payment down to a 38% DTI ratio. Then the government shares the cost for the next seven percentage points. I like this "loss share" component.

Second, the program is targeted at borrowers who may not already be delinquent on their loans, in addition to those who have already fallen behind. This eliminates the "My lender won't talk to me until I miss three payments" problem.

Third, borrowers are going to get up to $5,000 in principal reduction payments from the government, spread out over a period of five years. The idea is to help incentivize borrowers who are upside down to stay put during the period they are upside down, but paying at the reduced rate.

And now, the "bad":

First, the plan only applies to owner occupied homes with loans under the conforming loan limit. Some 40% of existing homes sold during the peak of the bubble -- 2005 -- were purchased as second homes or investment properties, according to the National Association of Realtors. Jumbo loan borrowers would also be excluded from the plan. These exclusions are understandable from a political standpoint. After all, officials don't want to be seen bailing out speculators or the rich. But they will also limit the plan's impact.

Second, the provision that would allow Fannie Mae and Freddie Mac to refinance borrowers into new loans with LTVs of up to 105% is somewhat troubling. Waiting and hoping for a home price rebound -- and refusing to just go ahead and foreclose on loans where borrowers have fallen behind and are upside down -- has proven to be a losing strategy. It's akin to kicking the can down the road, and it has resulted in billions and billions of dollars in industry losses.

Now, rather than cut their losses short, Fannie and Freddie will be allowed to refinance these outstanding mortgages into new lower-rate loans that feature LTVs of 80% to 105%. That means a portion of the new loans will effectively be unsecured. This exposes Fannie and Freddie to potentially larger losses down the road if home prices don't rebound and/or if borrowers just end up defaulting anyway. That, in turn, could result in some additional risk being priced into the GSEs' cost of funds.

So what's the problem? Taxpayers could ultimately get soaked if home prices don't rise in the coming few years. Those losses would come on top of any possible losses stemming from the recent surge in FHA loan volume. FHA, unlike most private lenders these days, will still extend mortgage loans at LTVs as high as 97%. That's a significant risk in an environment of falling home prices and rising unemployment.

Third, the plan still doesn't attack the principal reduction issue head on. Lenders and servicers may voluntarily apply any government aid toward principal reductions. But it appears term extensions and rate reductions will be the main technique used to reduce payments to the 38% and 31% thresholds. The Obama administration is hoping that the threat of bankruptcy cramdowns will inspire lenders to act. But that remains to be seen.

Fourth, in many hard-hit markets -- the ones where foreclosure rates are the highest, including Florida and California -- home price declines have been extremely severe. Even a $5,000 principal reduction incentive payment likely won't be enough to incentive those borrowers to stick around should hardship strike. And the more generous 105% LTV standard on Fannie and Freddie refinances won't make much difference.

Consider the following example from my own backyard, Palm Beach County, FL:

Let's say you bought a median priced home in the West Palm Beach market in December 2005, around the peak of the market. It would have cost you $408,200 at the time, according to Florida Association of Realtors figures. Let's be generous and assume you put 10% down, rather than finance with some 80/20 scheme. You would have had to cough up $40,820 and finance $367,380 -- leaving you with a mortgage with an initial LTV of 90%. Thirty-year fixed rates were around 6.3% at the time, so your payment (principal and interest only) would have been $2,273.98.

As of December 2008, just three years later, the median price of a West Palm Beach home is $246,000 (again, going from FAR data). That means your home would have lost $162,200 in value, or 39.7%. During that same three-year period, you would have only paid your mortgage principal down to $353,738.60 (about $13,600, or 3.7% of the original balance).

You would have $54,461.40 in equity, or a 13.3% equity position, assuming the original home did not lose or gain any value in the interim. Stated another way, your LTV would have declined to just under 87%, and the new Fannie/Freddie 105% LTV break would give you some relief.

But as I said earlier, prices haven't stayed the same. They've plunged almost 40%. That means you now have a mortgage with an LTV ratio of 143.8% (!) As you can see, even a more generous 105% LTV limit doesn't help you refi in a market like this one. And a $5,000 subsidy over five years doesn't do much to offset a $162,000 decline in value, much less incentivize you to stay put. This is why principal cramdowns/reductions are all but inevitable in hard hit markets -- Florida, California, and so on.

And now let's talk about the "ugly" part of this plan, the possibility that it will incentivize bad behavior (moral hazard) and more importantly, that it might actually DELAY a rebound in the housing market ...

As part of this program, the government could end up subsidizing mortgage borrowers, lenders, and servicers to the tune of more than $10,000. How is that fair to borrowers who played by the rules ... who didn't buy too much house ... and continue to pay their loans on time? Why are they left out in the cold? That's what many Americans are going to be asking, and what many politicians are going to be hearing from callers.

Moreover, market forces ARE working. Foreclosures are actually resulting in overpriced homes burdened with too much debt being moved into the hands of new buyers, who are paying drastically reduced prices. They can therefore purchase using a traditional mortgage. In markets where prices have fallen the most, home sales are currently rising smartly. Delaying and dragging out the downturn by artificially propping up home prices will arguably work against the market healing, even if it makes us all feel good for doing "something."

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