President’s HARP May Hit The Right Note

With his latest stimulus proposal (rebranded as a “jobs” act) dead on arrival at Capitol Hill, President Obama is casting about for ways to bolster the economy without having to go through Congress.

He seems to have found one that has a decent chance of actually succeeding.

The president announced Monday that his administration will help homeowners refinance if they are making their mortgage payments on time, even if they have little or no equity in their properties because of the sagging housing market. This worthy goal would be accomplished by relaxing certain terms of the Home Affordable Refinance Program (HARP), which was put in place in 2009 but never lived up to expectations.

While pricing details won’t be released until mid-November, the administration also said it will reduce loan fees charged by Fannie Mae and Freddie Mac, and waive fees for borrowers who refinance into shorter-term loans. Borrowers who have made at least six consecutive monthly mortgage payments will qualify.

The theory, a sound one, is that people tend to behave consistently. Those who have paid their mortgages on time and faithfully in our current environment, when their houses’ values have already dropped and their earnings have taken whatever hits they’re likely to take due to the weak economy, are generally apt to continue to pay their mortgages reliably. There are, of course, individual exceptions, but as a class such payers are a good bet. Giving these homeowners the benefit of today’s lower interest rates only increases the chances that they will pay back their loans in full and on time.

This isn’t a free transaction. Lenders and investors who bought securitized mortgages will get less income than they expected as borrowers refinance higher-rate mortgages. But residential mortgages have always been subject to prepayment, and prepayments almost always increase when mortgage rates drop and property owners are prone to refinance as a result. The current market is an aberration because even though rates have reached bargain-basement levels, reduced home equity has inhibited refinancing by otherwise qualified and responsible borrowers.

An admirable aspect of the administration’s plan is that it reverses an error dating back to the pre-recession mortgage boom. We should have learned a fundamental lesson from the mortgage crisis of the 1980s, which is that every loan should be based on the expected ability of a borrower to repay it, not just on the assumed value of the collateral. During the boom, lending institutions were willing to approve nearly any borrower because they erroneously assumed that if a borrower couldn’t pay, the home pledged as collateral could be sold at a high enough price to recover the unpaid balance of the loan. But some homes were never as valuable as their inflated appraisals indicated, while many others might have been sufficiently valuable at the time of the loan, but saw their values drop when housing demand evaporated. Either way, huge numbers of mortgages went sour.

The administration’s proposal focuses on current income, not home value, which is a more traditional and safer way of underwriting loans. Regardless of how much value their homes have lost, borrowers who refinance in the HARP program will be judged primarily on their ability to repay their mortgages instead of the strength of their collateral.

Another traditional aspect of mortgage lending that was largely jettisoned during the boom was a substantial equity requirement, typically 20 per cent. In the current environment, refinancing a loan with little equity does not create a loan that’s any riskier than the original. If a homeowner refinances a 6 per cent loan with no equity into a 4 per cent loan with no equity, he or she is not less likely to pay it back. In fact, the 4 per cent loan is less risky, because it is easier for the borrower to handle when money gets tight.

Thus the administration’s proposition actually takes some risk out of the housing market, while allowing large swaths of borrowers to benefit from today’s artificially low interest rates. I dislike these artificially low rates and the way they penalise thrift. But if we’re going to punish savers, we should at least allow borrowers to benefit; after all, that was the original point.

Overall, this plan is a net positive. Everyone wins except the lenders, who were always on the hook for prepayment, even before the housing market went bust. If it is well implemented, the reconfigured HARP should hit just about the right note.

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