February 13, 2012 | Issue Brief on Housing
FYI: Heritage WebMemos are now called Issue Briefs.
One of the troublesome aspects of President Obama’s State of the Union speech was that the much-hyped housing section was little more than a slightly revised version of a proposal from last fall. While last fall’s plan was limited to homeowners whose mortgages were held by Fannie Mae or Freddie Mac, the newly announced version allows homeowners whose mortgages are held by private-sector lenders and entities other than Fannie Mae and Freddie Mac to refinance their mortgages. The new plan uses the Federal Housing Administration (FHA), an entity that is already on the verge of needing a major taxpayer bailout. All homeowners, regardless of who owns their mortgages, would have access to streamlined refinancing methods and lower fees. Like several earlier housing refinance plans that failed to work, this version is unlikely to be any more successful.
Before the speech, there had been speculation that the President would announce a program that allowed homeowners to have their lenders reduce the amount of their loans. Some speculated that this reduction would be mandatory for lenders, but after the Federal Housing Finance Agency (FHFA) noted that such a plan would cost taxpayers an additional $100 billion in subsidies to Fannie Mae and Freddie Mac, that idea seems to have been dropped for now. The much smaller measure is simply the newest version of a poorly considered loan refinancing program.
The Newest Version of a Refinancing Plan
The latest version of the Obama refinancing plan is very similar to previous versions. As with the others, a homeowner must have a mortgage on a single-family, owner-occupied principal residence and be current on the mortgage for at least the past six months with no more than one late payment during that time. He or she must also have a FICO score (a measure of a borrower’s credit worthiness) of at least 580. The FICO score measures the borrower’s overall debt and credit history, and about 90 percent of borrowers have at least a 580. In addition, the homeowner must have a mortgage that is below the FHA loan limit in the area. Depending on the location, the FHA limit ranges from $271,050 in the lowest-cost areas to $729,750 in the highest.
Finally, the borrower’s home may not have a loan for more than 140 percent of the current value of the house. The Administration talks of additional measures that could include requiring the lender to forgive amounts above 140 percent of the current home value, but those measures would require congressional approval, which is not likely. Refinanced mortgages would use simplified criteria that eliminate the need for an appraisal and certain other items to speed the approval process.
Refinanced mortgages would be insured by the FHA. Supposedly to protect the already unsound FHA from additional losses, a separate fund would be set up within the FHA, with the cost of losses being covered by a tax of some sort on financial institutions. Both the new FHA fund and the new tax would require congressional approval, and both would be poor policy. The new fund is just an admission that many of these refinanced loans will subsequently fail. If they went into the normal FHA fund, they would eliminate its little remaining capital. A new fund is simply creative accounting designed to hide the program’s certain impact on the FHA and that program’s shaky finances. On the other hand, the new tax is based on a desire to punish banks, and it serves little purpose other than to tap a source of funds to pay for the refinancing program’s inevitable losses.
The newest plan also fills a gap in that previous plans included only mortgages owned by Fannie Mae or Freddie Mac. This one is specifically for mortgages owned by some private-sector entity. It also overlaps with the earlier versions in that all borrowers, no matter who owns their mortgages, would be able to take advantage of the streamlined procedures and lower fees. However, this new plan shares the same weaknesses of its predecessors: It promises much more than it can deliver.
There are a few positive features amidst the weaknesses. For one, the Obama plan adopts a version of a simplified disclosure statement, an idea that was developed by the American Enterprise Institute’s Alex Pollock. This simple disclosure would make sure that borrowers actually understand the terms of the agreement they are signing. In addition, the plan gives a homeowner who owes more on his home than it is currently worth an avenue to pay enough on the mortgage so that the loan will be less than the reduced value of the house in about five years. Taking advantage of historically low interest rates, the plan would encourage people to refinance into a 20-year mortgage instead of the standard 30-year mortgage. Doing so would further reduce the interest payment, and a 20-year mortgage sends less of the payment to interest costs. The added amount that goes to repaying the principal on the loan would shrink the amount outstanding rapidly enough to equalize the outstanding loan and the current home value.
Further Weakening an FHA Already on the Brink of Bailout
The latest Obama homeowners’ refinancing program would cause the FHA to suffer new losses at a time when the agency is almost out of capital. Supposedly creating a new account to hold the mortgages refinanced under the latest proposal would do nothing to change this situation. The agency’s latest annual report shows that it has about $2.6 billion in capital to pay for possible losses in its $1.1 trillion mortgage portfolio. This equals about $1 for every $400 of insured mortgages—far below the legally required $1 of capital for every $50 of insured mortgages. The report notes that in the past year alone, the agency saw its capital drop by $2.1 billion, and there is a 50 percent likelihood that the agency will need as much as a $43 billion bailout as soon as next year.
Since it was created in 1934, the FHA has focused on assisting moderate-income and low-income home buyers by providing them with insured mortgages and allowing them to make down payments as low as 3.5 percent of the purchase price. However, since 2007, the FHA has moved from insuring about 5 percent of new mortgages to about one-third of all new mortgages, as the size of its insurance portfolio tripled. Although the agency’s leadership confidently predicts that a recovering housing market will keep it from needing a taxpayer bailout, other experts make a convincing case that the agency is already underestimating the amount of risk in its portfolio, and a bailout is all but certain.
The latest housing refinancing plan would only make this situation worse. Close to half of those who received refinanced mortgages in earlier versions of the Obama mortgage refinancing program have ended up defaulting, and there is no reason to believe that this version centered on the FHA will do any better. Hiding the new losses in a separate fund is just accounting subterfuge. As the losses mount from this effort, the FHA’s tiny remaining capital cushion will disappear, and it will need a taxpayer bailout. All that the proposed new tax on banks would do—if it was approved—is fund part of that bailout. The rest of the bailout would come out of the same taxpayers who have had to prop up Fannie Mae and Freddie Mac.
No Government Magic Bullet Will Work
As with earlier versions, the newest Obama home refinancing plan is more hype than substance. This version also requires several features, including a new tax on financial institutions, that are bad policy and would do nothing to help revive housing. The fact remains that there is no magic government solution that will make the current housing mess go away. The industry will have to grow out of the current slump over time.
David C. John is Senior Research Fellow in Retirement Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.
David C. John, “Latest Obama Mortgage Refinance Plan Another Dud,” Heritage Foundation Foundry, October 25, 2011, at http://blog.heritage.org/2011/10/25/latest-obama-mortgage-refinance-plan-another-dud.
Margaret Chadbourn, “Fannie, Freddie Writedowns Too Costly: Regulator,” Reuters, January 23, 2012, at http://www.reuters.com/article/2012/01/23/us-usa-housing-fhfa-idUSTRE80M2BW20120123 (February 10, 2012).
Alex J. Pollock, “The Subprime Lending Disaster and the Threat to the Broader Economy,” testimony to the Joint Economic Committee, U.S. Congress, at http://jec.senate.gov/archive/Hearings/09.19.07%20Subprime%20Spillover/Testimony%20-%20Alex%20Pollock.pdf (February 10, 2012).
Annie Lowrey, “F.H.A. Audit Sees Possible Bailout Need,” The New York Times, November 15, 2011, at http://www.nytimes.com/2011/11/16/business/economy/auditor-says-fha-could-need-bailout.html?_r=1 (February 11, 2012).
Joseph Gyourko, “Is FHA the Next Housing Bailout?” American Enterprise Institute, November 11, 2011, at http://www.aei.org/papers/economics/financial-services/housing-finance/is-fha-the-next-housing-bailout (February 11, 2012).