More on refinancing negative-equity loans

 Josh Rosner over at The Big Picture has a response to a plan similar to the one I proposed last week. I argued that breaking-off the underwater part of a mortgage and turning it into a full-recourse uncollateralized loan was likely to have little effect, since the collateral wasn't going to magically be worth more just because the banks needed it to. I wrote:

The government could create a facility that lends money to underwater homeowners that need to free themselves from a home.

This is not a giveaway, it is a loan. This is not a below-market-rate loan, and therefore carries no implicit subsidy. The loans should be made at a rate similar to or slightly higher than the original mortgage rate. Home-owners who are underwater and are being held-back from taking a job in a different area should be offered the loans, which would be contingent on a job offer. The loans would be used to pay-off negative equity at the time of a home sale. The borrower could then free him or herself from the home anchoring him or her down and return to employment
...
If the lender vowed to reduce the rate on the loans by a set amount if the borrower transformed the loan into a second lien on any new property bought, it could furthermore enhance the quality of these loans. These loans could then either be kept until maturity or sold to banks for securitization

The original idea behind this was that, especially for a distressed, undercollateralized loan, if you increase the quality of the borrower, you increase the value of the loan. I argued that because the Fed owns $2Tin MBS and Fannie and Freddie guarantee so much of the rest, it would actually be in the financial interest of the taxpayer to do this.

Josh, however, is responding to a slightly different plan. a mass, streamlined refinancing of underwater-mortgages. I tend to agree with some of the logic behind the idea, but, operationally, it would be a total nightmare.  I still think the best way to deal with it would be for banks to allow homeowners with no second lien to convert the underwater portion of their mortgages into a separate, uncollateralized recourse loan and refinance the house at an appropriate LTV. This help people sell their homes and downsize or move, without being forced to default on their debt.  Josh didn't respond to my plan. Josh doesn't know that I exist. In fact, judging by the traffic stats, only about 1.7 people have ever read this blog, but I like to chime in on everything.  Here is Josh's objections (along with my response):

- As a result of another prepayment-shock and the inability to model future prepayment shocks, investors would become even more unwilling to invest in MBS gong forward, or would begin to demand higher yields going forward; unwilling to invest in MBS going forward, or would begin to demand higher yields going forward;

 Oh, no! The government would stop subsidizing people earning abnormally high yields with unusually low prepayment rates! Shut up, Josh. Anyone who bought MBS in size knows that there is an embedded call option in the loans and how negative convexity works against you when interest rates drop. I agree that the streamlined refi process would be a mess, but that doesn't matter for a plan like mine.

- The interest rate risk that this would cause, as banks and the GSEs themselves all had to re-hedge their books at the same time, could precipitate a systemic risk issue;

Yes. They are all going to have to do that at the same time. By this same logic, why didn't the unusually low prepayment rates wreak havoc on their prepayment models and therefore their hedges?

- The prepayments would cost investors more than half a trillion in lost interest income;

I was under the impression that the government was trying to get out of the business of subsidizing bond holders at the expense of everyone else. I'm sure investors will find new ways to reach for yield or invest that money in, oh, I don't know, a value-creating process?

- Such a “streamlined” refi program would cost state and municipalities billions of dollars in transfer fees that they would normally be able to charge on a refinancing;

Well, if it wasn't for the program, the states and municipalities wouldn't get any fees, because underwater homes can't be refinances anyway. So they aren't really losing anything at all. They are just a road-block that's being worked around. Since the states just got $26B from Uncle Sam last week, they should just keep their mouths shut. Not to mention the benefits they'll reap from would-be defaulters and foreclosures staying current.

- Keeping borrowers in their homes with rate reductions could be argued to be consistent with maximizing value under conservatorship. A streamlined and across the board refi program that treats all borrower LTVs and other features the same would appear to violate the conservatorship;

I agree with the first part. The second part I'll leave to the lawyers. I do think that a mass-rate-decrease might be the cheapest way to minimize costs for the guarantors, though.

- The GSEs, according to their trust agreements, are prohibited from soliciting prepayments. If they were in receivership these agreements could be abrogated but they would still have to pay value on the contracts; and

- Servicer’s could solicit borrowers to prepay on the program but it would be a nightmare to operationalize and oversee such a massive program. 

Touché.