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Why Are More Loans Not Being Refinanced?

October 25, 2010, Updated May 28, 2012

While mortgage interest rates are at their lowest levels since 1945, millions of mortgages that carry interest rates of 6% to 9% or even higher, are not being refinanced. The reasons for this involve Fannie Mae and Freddie Mac, the two secondary market giants now in Government conservatorships, in a central role.

The problem is perhaps best seen through the eyes of borrowers who are unable to refinance. Each unsuccessful borrower cited below is representative of a sizeable group of unsuccessful borrowers.

 Fannie Mae and Freddie Mac Have Become Excessively Restrictive

Adam was turned down for a refinance because he did not meet the new stiffer underwriting and pricing requirements set by the agencies in their standard programs. His credit score, which was acceptable when he got his loan before the crisis, is not high enough to meet the new requirements.

It clearly was appropriate for the agencies to correct the excessively liberal rules that had prevailed during the go-go years, which contributed to the financial crisis. However, they have reacted to their excessive liberality before the crisis by becoming excessively restrictive in the aftermath. Their underwriting and pricing structures are designed to maximize their net earnings, as if they were still private firms.

Fannie and Freddie are now part of the Government, and should set their underwriting rules and pricing adjustments not to maximize net revenue but to break-even over a long time horizon.

May 28, 2012 Update: No change required.

 There Should Be No Maximum LTV on the HARP Program

Barbara is one of many homeowners who bought during the go-go years and who now owe more than their houses are worth – she is “underwater”. She applied for a loan under the Home Affordable Refinance Program (HARP), which was designed to make refinance possible for underwater borrowers who are current on their payments and whose loans are owned by Fannie or Freddie. Barbara is ineligible, however, because she is too far underwater. Her loan-to-value ratio (LTV)  is 130% and the agencies have set a 125% maximum on fixed-rate mortgages, 105% on adjustables.

A maximum LTV in the HARP programs cuts out a sizeable segment of the potential market, for no good reason. The agencies are already on the hook for any losses on high LTV loans, and a rate reduction can only reduce the probability that a default will occur that would trigger the loss. Indeed, the reduction in expected loss from a rate-reducing refinance is larger on a 150% LTV than on a 125% LTV. The default rate has to fall only half as much on a 150% loan as on a 125% loan to generate the same reduction in expected loss.  

Fannie and Freddie should scrap the LTV maximum in the HARP program, for which there is no rational reason, thereby also eliminating the need for appraisals on HARP loans.

May 28, 2012 Update: Version 2 of HARP, which became effective March 17, 2012, eliminated the 125% LTV ceiling on fixed-rate mortgages, but retained the 105% maximum on adjustables. This has resulted in a marked pickup in HARP activity, yet it remains well below what it could and should be.

Some potential borrowers find that their lender refuses to go above 125%, or requires an appraisal, despite the change in agency policy. (If there is no maximum LTV, an appraisal is redundant, or should be).  Other borrowers have been frustrated by complications that can arise when there is a second mortgage, or when the existing mortgage has lender-paid mortgage insurance. Agency rules also impose less risk on lenders servicing the existing loan than on other lenders, which reduces the ability of borrowers to shop for the best rate.

 Too Few Lenders Make 125% HARP Loans

Charley was turned down for a refinance under the HARP program, although his LTV was only 120%, which made him eligible under agency rules. Nonetheless, the lenders Charley approached would not make the loan. They told him that their maximum LTV was 105%, and some said that it was 95%. Charley could have refinanced if he knew where to go, but he didn’t and gave up the search.

I did a quick and dirty survey and found that HARP loans above 105% are not available from brokers or from smaller lenders who sell to wholesalers who in turn sell to the agencies. HARP loans exceeding 105% are only available from some of the lenders who sell directly to the agencies.

Freddie Mac has a list of HARP lenders at http://www.freddiemac.com/cgi-bin/homeowners/relief_refi.cgi, but it is extremely difficult to find. If Fannie has one, I could not find it. The Freddie list has 27 lenders, 14 of which do 125% loans, of which only 4 have wide multi-state presence: Aimloan.com, SunTrust Mortgage, Quicken Loans and RBC Bank.

Fannie and Freddie ought to do a better job of informing potential borrowers how to find a lender who will make 125% HARP loans, and they should review their policies that have discouraged broader lender participation.

May 28, 2012 Update: This conclusion still holds but it now applies to lenders who will make HARP loans with no limit.

 Borrowers With LTVs Above 105% Who Have PMI Can Refinance Only With Their Current Servicer

Doris’s situation was the same as Charley’s, including an LTV of 120%,  with one difference. Doris’s existing loan carries primary mortgage insurance (PMI). The lenders who turned her down told her that the mortgage insurer had to agree to shift the MI policy to the new loan, but would not do so in her case.  

Under HARP rules, if there is no MI on the existing loan, none is required on the new loan. If there was MI on the old loan, as in Doris’s case, it will be carried forward on the new loan, provided the PMI firm agrees. But if the current LTV exceeds 105%, they won’t agree unless the new loan is being made by the existing servicer.

Doris was not aware that only the lender servicing her loan can shift the mortgage insurance policy from the existing loan to a new one. PMIs will not shift the mortgage insurance to a new loan with a different lender when the LTV exceeds 105%.

Fannie and Freddie ought to inform potential HARP borrowers who have mortgage insurance and LTVs greater than 105% that they can only refinance with their current lender, and they should examine whether there is anything they can do to remove the PMI roadblock. 

May 28, 2012 Update: This conclusion also holds but now applies to the new LTV limits.

 HARP Should Be Expanded to Cover Mortgages Not Owned by Fannie or Freddie

Ethan is an underwater borrower in good standing whose loan is not owned by Fannie or Freddie. His only possibility of a refinance is an FHA program that requires the existing lender to write-down the balance to 97.75% of house value. Since Ethan is making timely payments, the lender has very little incentive to do that.

Ethan had no say in who ended up owning his loan, from his perspective it was a coin toss that came up tails and made him ineligible for HARP. The out-of-luck group to which Ethan belongs includes a large number of sub-prime borrowers who meet their obligations faithfully while paying rates up to 9% and even higher.

There is no good reason why such borrowers have to be left entirely out in the cold. While including these borrowers in HARP would expose Fannie and Freddie to risks they did not have before, the agencies could set payment performance requirements and charge risk premiums large enough to protect taxpayers while still offering many of these borrowers substantial relief..

Treasury should have the agencies develop a HARP1 program covering loans they do not now own that would be subject to underwriting rules and price adjustments consistent with the Government breaking even.

May 28, 2012 Update: Nothing has been done about this.

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