Thursday, July 29, 2010

Lawler: “Slam-Dunk” Stimulus? MS = Missing Something!!!!

by Bill McBride on 7/29/2010 04:40:00 PM

CR NOTE: There have been a couple of "stimulus" proposals making the rounds over the last couple days from major analysts. Housing economist Tom Lawler takes a look at one proposal from Morgan Stanley ... the following lengthy discussion is from Lawler:

“Slam-Dunk” Stimulus? MS = Missing Something!!!!

Early this week Morgan Stanley put out a piece entitled “Slam Dunk Stimulus,” in which MS analysts argue that changing mortgage refinance “requirements” (for GSE or government mortgages) would “inject a significant amount of stimulus into the US household sector,” have “zero impact on the budget deficit,” and would “not require an exit strategy” and would “not distort markets.”

Here is the gist of their argument:

“If it were possible to inject a significant amount of stimulus into the household sector of the US economy over the near term and this stimulus had zero impact on the budget deficit, did not require an exit strategy, did not distort the markets, and took effect almost immediately, wouldn’t it seem like a slam dunk? Such an option actually exists in the form of a change to mortgage refinancing requirements. The Fed – and market forces – have pushed mortgage rates to historic lows. However, many homeowners are unable to take advantage of the low rates because they are blocked from refinancing by a high loan-to-value ratio (LTV), appraisal problems, unemployment, and low credit score, etc. This problem could be addressed if the Government merely recognized the guarantee that already exists on the principal value of a very large portion of the mortgage market – specifically, the mortgages that are backed by Fannie, Freddie and Ginnie – and acted to streamline the refi process.”
The analysts note that with the “median” universe of outstanding 30-year fixed-rate mortgages being around 5.75%, and with current 30-year FRMs being around 4.50%, the potential rate reduction could average about 125 bp, which could translate into stimulus of around $46 billion a year.

The “logic” of the proposal is straightforward: if the GSEs, FHA, and VA already “own” the credit risk on the mortgages they own or guarantee, then allowing a more “streamlined” refi process “makes sense.” The authors note that “(t)he notion that the Federal government should recognize the mortgage guarantee that is already in place when establishing the qualifications for refinancing has been raised by others in the past.”

What the authors do NOT note, however – and this is truly shocking -- is that this “notion” was a major reason why the Administration/the GSEs rolled out the well-intentioned but poorly executed Home Affordable Refinance Program, or HARP!!!!! Recall that originally this program allowed GSE-owned refis up to a CLTV of 105% (the original reason for the restriction being that loans with higher CLTVs were NOT “TBA[to-be-announced]-eligible (which is NOT determined by the GSEs, by the way!!), though later this maximum CLTV was upped to 125%. In addition, FHFA “ruled” that loans with original LTVs at or below 80% that did not require mortgage insurance, but which today had current LTVs above 80%, did NOT require new mortgage insurance under the program despite wording in the GSEs charter suggesting otherwise – with the explicit rationale for the exemption being that the GSEs already “owned” the credit risk on the mortgages!!!!

How these analysts could roll out this “slam dunk” proposal without even MENTIONING the HARP is astounding! The analysts also don’t even MENTION the FHA’s streamlined refinance program!!!! (The underwriting requirements of which were tightened up a bit last September because of program “abuses.) This is an almost inconceivable miss on their part!!!!

The analysts also display a complete lack of understanding about the refinance process, transactions costs, and mortgage rates. E.g., the authors, presumably citing Freddie Mac’s Primary Mortgage Market Survey on average 30-year mortgage rates, note that current rates are about 4 ½%. However, that 4 ½ % “quote” (the latest survey showed 4.56%) includes a 0.7 point fee. More important, however, there are SIZABLE transactions costs associated with refinancing a mortgage.

As an example, I went to Chase Mortgage’s website this morning, trying to get a quote for a refinance of a $180,000 mortgage on a property currently valued at $200,000 in Virginia. I “clicked” that my credit was “very good” (one below “excellent,” which is actually closer to the truth!!!). The first quote was 4 ¾% with 1.125 “loan discount points.” Here was the associated closing cost information Chase’s website produced.
Closing Costs, $180,000 refinance, 30-year FRM, interest rate of 4.75%, Chase Mortgage
Title Insurance$446.40
Courier/Messenger Fees$35.00
Processing/Underwriting Fee$595.00
City/County Tax/Stamps$585.00
Application Fee$395.00
Recording Fees$46.00
Abstract Title Search$180.00
Settlement/Closing Fee$387.50
Tax Service Fee$84.00
Loan Discount Points$2,025.00
  Total Closing Costs$4,778.90
  
Prepaid Fees:  
Harzard Insurance Premium$450.00
Mortgage Insurance$144.00
Per diem interest (18 days)$374.72
Mortgage Insurance Premium$0.00
Escrow Fees 
Hazard Insurance Reserves$75.00
Real Estate Tax Reserves$500.00
  
Total Cash Needed at Closing$6,322.62


The website also said that for a 5% rate my discount points would be reduced to 0.25, but my total closing costs would still be $3,203.90 (and total cash needed at closing would be $6,322.62).

Now if I were in a situation that I either couldn’t or didn’t want to pay any closing costs, I’m not sure what Chase’s quote would be for a no-closing-cost loan (they don’t show that option). But using a quick and dirty “yield per point” approach, I’d probably get a rate quote of around 5 ½% -- 100 basis points above the rate used by the hapless Morgan Stanley analysts in their “stimulus” piece!!! In the mortgage (and housing world) transactions costs are a BFD1, and it’s pretty shocking the MS analysts don’t appear to know that!

What the analysts SHOULD have done, of course, was to focus on the HARP and the FHA streamlined refi programs, and suggest potential changes that might make the programs more successful.

Fannie Mae, by the way, earlier this week put out an updated “frequently asked questions” piece on the Home Affordable Refinance Program.

Here is a poorly written piece I wrote to someone else early this morning who asked what I thought of the Morgan Stanley piece. (I just don’t feel like rewriting/editing).

Actually, HARP attempted, badly, to "do" this (streamline the GSE refinance process for high LTV loans) by "allowing" qualified borrowers whose loans were owned/guaranteed by the GSEs to get refi loans with current LTVs up to 125%. Moreover, for loans with original LTVs of 80% or below that did not have private mortgage insurance, the requirement that the borrower get private mortgage insurance on the new loan if the current LTV were above 80% was waived. The logic was explicitly related to the fact that the GSEs already “owned” the credit risk. However, it's generated a surprisingly low level of activity, for a couple of reasons:

1. The GSEs have "loan level price adjustments" for high LTV/low credit score combos. E.g., in the Fannie refi plus program, the loan level price adjustment for borrowers with a LTV over 97% and a credit score under 640 is 2% (actually it shows a higher number, but the cumulative fees are capped. See here.) Thus the "savings" to some borrowers isn't as great as it first appears. Note that some of the loans eligible for refi had higher guaranty fees to begin with because they were "riskier2.”

2. If the current loan has mortgage insurance, the new loan has to have mortgage insurance (with the same coverage) as well. Apparently this has been a troublesome process. The GSEs' reason is obvious: it had credit enhancement on the existing loan, so ... But, as I noted before, for loans that didn't originally have MI but whose current LTV exceeds 80%, the FHFA opined that new MI was "not needed" despite some folks' interpretation of the GSE charters, with the logic being that the GSEs already owned the credit risk.

3. There's no "cash out" option (except I think for a $250 de minimus). This makes sense as well.

4. Borrowers underwater or with very little equity in their homes are extremely averse to having to pay ANYTHING at closing on a refi (or to roll such costs into the loan balance, although the HARP does allow “typical” closing costs to be financed). As a result, to "make sense" most such borrowers would need to take out a "no closing cost" mortgage where the rate charged is higher but the originator recoups its costs/fees by packaging the loan into a "premium" (above par) MBS. As a result, such borrowers’ interest rate on a refi is materially above, say, the Freddie PMMS rate – by at least 50-75 bp.

5. Loans with LTVs above 105% are not eligible for inclusion in a "TBA-eligible" MBS/PC, but must be included in a separate type of pool with a separate prefix3. This can adversely impact pricing of the MBS, and as such on the loan.

6. The HARP is limited to borrowers who are current on their loans.

7. Many borrowers aren’t that aware of HARP, and don’t know if their loan is owned or guaranteed by Fannie or Freddie – though both entities have an easy to use website that borrowers can use to find out. When I’ve gone to online sites to get refi quotes, none of the lenders really mention the HARP on their refi quote page, though some mention it if you do a site search – and a few suggest that the HARP is only available to loans that they service, which if believed by the borrower enables lenders to be “less aggressive” on HARPs (and refis in general), offering not great rates and charging more fees than “needed.”

Obviously, the GSEs would not be and should not "refi" FHA/VA/other loans with high CLTVs, as they do not currently own the credit risk.

The FHA has had a streamlined refi process for quite a while. However, last year it "tightened up" some of the underwriting requirements because of some of abuses. See, Letter 09-23.

So...the HARP was sorta/kinda designed to make LTV less of an "issue" for borrowers with loans owned/guaranteed by the GSEs to refinance. However, for a number of reasons (including those shown above), the "effective" rate borrowers with not great credit scores AND with high LTVs are able to get on a refinance is a lot higher than many expect. And given the transactions costs involved in a refi, even very good credit borrowers cannot get a no-closing-cost rate anywhere close to 4 ½% on a 30-year FRM.

The "winners and losers" section of the “more streamlined refi ‘proposal’” -- including the losers, which would be holders of the "premium" MBS that are paid off -- misses a big point. MBS investors would "lose" the cash flow associated with holding the "premium" MBS that are paid off faster, and this loss would not be "ameliorated" by a resumption of MBS purchases by the Fed. In simple terms: If I'm getting a 6% MBS coupon and you are paying, say, 6.5% on your mortgage (with 25 bp going to servicing and 25 bp being a "guaranty fee"), and you are able to refi into a, say, 5% mortgage and I find my 6% MBS pay off and have to "reinvest" in a 4.5% MBS, you "save" 150 bp a year but I lose 150 bp a year. Now it is true that the Fed holds a lot of MBS (though not many with that high a coupon); the GSEs also hold a lot; and as a result "the government" would "lose" (resulting, of course, ultimately in higher future taxes), other losers would be banks/thrifts (and their owners/shareholders), pension funds, MBS funds, etc. In other words, some folks interest income would fall even as other folks mortgage interest expense would fall, and if the GSEs/FHA offered “more aggressive” streamlined refis the result would in part at least be a sorta/kinda transfer or wealth, and the net stimulus effect wouldn't be anywhere close to what Morgan Stanley analysts say.

So..."The notion that the Federal government should recognize the mortgage guarantee that is already in place when establishing the qualifications of refinancing" has not only "been recognized by others in the past" (page 4); that notion was explicitly behind the Home Affordable Refinance Program. There have been a number of technical issues and other impediments that have significantly limited the amount of refinancing done under the HARP (and the FHA streamlined refi program), and these programs can and probably should be “tweaked” (and quite frankly I think the GSE loan-level price adjustments should be lowered). However, in assessing the potential volume and the likely “savings,” analysts need to take into account the non-trivial costs associated with refinancing, How MS analysts could not take these into account, and not even MENTION the HARP and the FHA streamlined refi programs is something that is almost inconceivable.

Footnotes:
1 BFD: Big Financial Deal
2 Since Fannie Mae already has the risk on the existing mortgage loan, why are LLPAs required?
"LLPAs are required because Fannie Mae is putting a new loan on our books, which involves certain basic processing/administrative costs, accounting considerations, and the requirement for us to hold capital (based on the current risk) against every loan we acquire. Some Refi Plus loans may get better pricing than the borrower’s original loan did because risk characteristics may have changed."
3 Why are loans with LTVs above 105 percent not permitted to be commingled in standard Fannie Mae TBA-eligible MBS pools?
Permitting loans with LTVs greater than 105 percent in TBA (to-be-announced) securities would have tax reporting implications for investors that are subject to certain income and asset tests for federal income tax purposes (e.g., REITs must derive at least 75% of their income from real estate assets). Right now, 100 percent of Fannie Mae’s TBA MBS qualify as real estate assets, and thus there is no need for additional tax reporting. In addition, the introduction of LTVs in excess of 105 percent could create greater uncertainty around prepayment speeds for TBA pools since there is no significant track record of data on prepayment of loans with LTVs above 105 percent.

CR Note: This post was from Tom Lawler.

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