This Mortgage Loan Program Is Worthless

 | Oct 26, 2011 | 4:00 PM EDT
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On Tuesday, the Obama administration unveiled its latest residential mortgage loan modification program. It's being referred to as HARP 2: Home Affordable Refinance Program. It's being hailed by many as big step forward in helping consumers who do not qualify for lower rates because they lack the necessary equity to meet current Fannie Mae and Freddie Mac guidelines.

Ed Demarco, the acting director of the Federal Housing Finance Agency, the organization set up by Congress to oversee the U.S. government's conservatorship of Fannie Mae and Freddie Mac, believes that 1.8 million homeowners will be eligible to refinance under these new guidelines. Mark Zandi, chief economist at Moody's Analytics, believes it will be closer to 1.6 million additional loan modifications.

The reality is that statistically, the program will have no impact on anyone, as almost nobody will qualify.

What Demarco and Zandi have failed to account for is how many people will not meet the income guidelines necessary to qualify. Of the 1.8 million people who meet the negative-equity criterion to qualify to apply under these new rules, very few will meet the other criteria.

Loans are underwritten to the 3 C's of credit: character, capacity and collateral. Character is determined by credit score, capacity is a measure of debt service as a percentage of income, and collateral is home equity and other savings.

Since 2008, the minimum criterion in each category that is needed to be able to qualify for a mortgage loan has increased dramatically. Credit score requirements have gone from no stated minimum to 720. As for capacity, income required has increased by about 40%. And home equity or collateral has increased from 0% to 20%. And those are the minimums, all of which must be documented.

And that gets us to the problem with this new program. Most of the mortgagors who are ineligible to refinance into the current lower rate environment from those that persisted five years ago are concentrated in five metro areas: Las Vegas, Phoenix, San Francisco, Los Angeles and San Diego.

These are the areas that have experienced the greatest reduction in values since the market peaked and the crisis began in 2007. Because of that, most people who purchased homes in these areas at any time after 2000 are, on average, now upside-down and ineligible to refinance under the current low rates.

However, these areas were also the ones with the largest increases in values between 2000 and 2007. The principal reason was that these were the areas where no-income-verification loans proliferated.

And that happened because World Savings, the creator of the no-income-verification mortgages, sold them in these areas aggressively for years before expanding to the rest of the country.

World Savings' success with these loans spurred other lenders to do the same. And that drove real estate prices up rapidly.  

World Savings traded on the NYSE under the name Golden West Financial and was sold to Wachovia in 2008. Wachovia failed shortly thereafter and was taken over by Wells Fargo (WFC), largely as a result of the no-income-verification loans it inherited from the World Savings default.

Coming back to current events, many of the upside-down mortgagors didn't have the documented income to qualify for a Fannie or Freddie loan when they bought the properties. On top of that, the income requirements have increased by about 40% since then. After adjusting for the lower rates that exist today, the income necessary is 25% higher than it was in 2007.

The bottom line is that very few people will meet the new more stringent income and credit guidelines, regardless of the waiver of collateral value issues.

A lot was accomplished, however, in putting this program together. The government and multiple private-sector parties got together and created a platform and system for refinancing mortgages in bulk. And that is impressive.

Once all interested parties realize that the rules are still too restrictive, they may loosen them further. There is political risk in such an approach, but some high-profile policy makers and analysts are becoming increasing vocal about the necessity to resolve the housing crisis before the economy can grow.

In the past week, Federal Reserve Bank of New York President William Dudley, Federal Reserve Governor Daniel Tarullo and Harvard professor Larry Summers have all voiced concern about housing and the need to address it.

That may get some activity started within policy circles; but this latest initiative, HARP 2, will have no impact.

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