President George W. Bush signed the Housing and Economic Recovery Act of 2008 last week. The event is remarkable in many ways.
For one, it showcases the governments emphasis on making sure that the agency mortgage market continues to function as it puts the U.S. government squarely behind Fannie Mae and Freddie Mac. A separate part of the legislation the Hope for Homeowners Act was specifically designed to come to the aid of distressed borrowers.
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Despite the bills good intentions, however, mortgage-backed participants have concerns about the efficacy of this bill. Will it allow the GSEs to provide enough of a backstop? Furthermore, will it negatively affect existing markets, particularly TBAs? Also, does it have enough reach so that it covers the really distraught borrowers?
Although, from a credit perspective, placing the government squarely behind the GSEs is a positive for both agency MBS and agency debentures, its still unclear from a supply-and-demand vantage point what the exact effect would be on mortgage-backeds, according to a recent Merrill Lynch report that analyzed the housing bill.
The bill does not address the issue of portfolio growth, although theres a clear focus on capital, with Freddie Mac recently stating that it is considering reducing its portfolio as well as raising equity, said Akiva Dickstein, managing director and co-head of the U.S. rates and structured credit research group at Merrill. However, while, in the past, many government officials have suggested that the agencies should hold fewer mortgages, in recent months there has been more support for the GSEs to have a bigger participation in the mortgage markets with the goal of lowering mortgage rates.
He noted that mortgage rates have come up a lot compared to a year ago, with recent Freddie Mac survey results showing mortgage rates increasing to 6.63% the highest level since the summer of last year.
Another aspect of the bill is establishing higher loan limits for both of the GSEs and the Federal Housing Administration (FHA). Many investors have expressed concern that this would increase the negative convexity of MBS and negatively impact the TBA market, if these higher-limit loans are included in TBA pools.
Dickstein said that jumbos have traditionally prepaid faster because of factors such as increased borrower sophistication and higher loan sizes. Models are pretty well set up to take that into account, Dickstein said. He added that the inclusion of higher-limit loans into TBA might decrease the value of these securities, but not by much, probably only as much as five ticks in terms of option cost deferential. This may not be enough to segment the market, he said.
RBS Greenwich Capital (RBSGC) analysts said that the Federal governments enhanced backstop of Fannie Mae and Freddie Mac should end fears that the agencies could cause a widespread market meltdown. The question now turns to the ability of these agencies to provide support to the mortgage market.
Analysts said that even with the GSE support package, they believe that other factors such as increased guaranty fees will likely make mortgage financing rates for homebuyers modestly more expensive. Thus far, they said, mortgage rates have widened versus Treasurys, although still by less than 25 basis points.
On the MBS side, the higher costs in obtaining a mortgage could potentially dampen prepayment speeds.
Higher borrowing costs and tougher underwriting standards will slow down refinancing activity and future prepayment speeds, said George Ju, MBS strategist at RBSGC.
Ju said that slower prepayments will boost the performance of IOs. Slower prepayments lengthen the weighted average life, which increases the value of Trust IOs.
Also, slower speeds make mortgage convexity less negative, which may reduce the demand for convexity hedging.
Giving Hope to Homeowners
The Merrill report also talked about the Hope for Homeowners Act, which it called an essential, core component of the new bill. The report noted that this closely resembles the original bill submitted by Barney Frank (D-Mass.)in the House of Representatives and Christopher Dodd (R-Conn.) in the Senate.
One question is whether the banks and servicers will participate the main gist of the proposal is allowing the refinancing of an eligible loan into a new FHA-insured mortgage. The investors are required to forgive a portion of the current loan so that its loan-to-value ratio is reduced to 90%; the reduced LTV is actually needed for FHA refinancing.
The basic idea is that the servicers or banks whoever is servicing the loans look at different types of loss mitigation options, Dickstein said. With all the options, investors take a loss because in these cases, a part of the principal has been written off. However, he explained that by allowing loans to refinance into an FHA mortgage, investors may be able to obtain a better recovery than they could by repossessing the home. He noted that there is an issue of timing: with an FHA refinance, the investors take on an upfront loss, which could accelerate realization of loan losses. This generally stands to benefit the top of the capital structure while diminishing the value of the lowest tranches, which would be written down more quickly, Dickstein explained.
In terms of borrowers eligible under the act, the Merrill report said that subprime borrowers might make up the biggest component. Compared to other loans, subprime experience the highest rate of delinquency, sometimes as high as upwards of 20%, Dickstein said. This is compared with Fannie Mae and Freddie Mac mortgages, which have reported about a 1% delinquency rate.
Glenn Boyd, the head of securitization research at Barclays Capital, estimates that the Hope for Homeowners Act applies to about 25% of delinquent subprime borrowers, taking into account debt-to-income ratios and other restrictions.
The issue of debt-to-income ratio has an attendant moral hazard, according to Boyd. In the original Frank proposal, the ratio of a borrowers mortgage debt to income would have been above 35%. But this was lowered to 31% in the approved version of the bill.
The fear is that borrowers are going to deliberately go into default to qualify for debt forgiveness, although there are other obstacles to prevent many people from doing that, Boyd said. He qualified, however, that the Board made up of the Secretary of Department of Housing and Urban Development, the Secretary of U.S. Department of the Treasury, the Federal Reserve Chairman and the Federal Deposit Insurance Corp. Chairman could raise that percentage for moral hazard reasons.
Aside from subprime borrowers, Boyd said that both prime and Alt-A borrowers could in principle qualify under this act; however, servicers are less likely to offer debt forgiveness to borrowers who are not on the brink of delinquency or not delinquent.
Boyd believes that there are economic reasons for a servicer to pursue an FHA refinancing as opposed to other loan modifications both for the servicer and the bond holder.
If you foreclose, its going to take a year or more to liquidate [sell] the property, and loan servicers could advance interest payments, resulting in higher loss severity, Boyd said. This can hurt some bondholders.
More importantly, if a delinquency results in a real estate owned (REO) property, its basically a fire sale at a discount, Boyd said, which could be prevented by doing the FHA refinancing
You could save 20 points or more just by avoiding a fire sale, Boyd said. In many cases, severities could be lower by a factor of three by doing an FHA refinancing instead, in instances where assets are underwater or have a very high expected loss severity. He said that because of the economic benefits of doing the FHA refinancing, he believesthat many servicers are going to actively promote this, citing Ocwen Financial Corp. as an example of a servicer with demonstrated ability to perform modifications on a substantial scale.
He acknowledged, however, that an impediment to the implementation of this type of refinancing is the lack of FHA underwriting guidelines, which usually go through months of consultation before coming to fruition. Boyd said that since this bill is part of the governments emergency rescue effort to homeowners, policy makers will not want to allow this lag time. He believes that this is going to accelerate the process on the FHAs part. In term of the lenders, their systems could more easily be put in place to implement the FHAs underwriting policies, so Boyd does not expect any hitches there.
Boyd thinks that the option to refinance into an FHA loan can help stabilize markets in some of the worst hit areas, he said. These areas, such as Sacramento, California, will likely have many REO or distressed sale properties contributing to house price depreciation a situation that this bill addresses.
The option to refinance into an FHA loan is probably not going to help the aggregate much but should be a big boost to areas where you have incredible foreclosure or REO pipelines, Boyd said.
Legal Implications
The housing legislation has a number of legal and regulatory ramifications, including those that have to do with refinancing existing subprime mortgage loans into FHA-insured mortgage loans, licensing for loan originators and Truth in Lending Act changes, according to Jeffrey Taft, a partner in the Washington office of Mayer Brown.
Taft explained that the servicers reliance on the Acts safe harbor provisions could protect them from liabilities regarding their decision to refinance pooled mortgage loans. This might increase the willingness of servicers to participate in the Hope Program.
According to the Act, the borrower who has agreed to refinance his or her mortgage into an FHA loan has to share the value of the appreciation of the property with the government, the value of which ratchets down as time goes on, Taft explained. He added that the legislation permits the FHA to use part of this amount to pay off some second lien holders who relinquished their subordinate liens for the original loan.
Taft also refers to the S.A.F.E. Mortgage Licensing Act, which is expected to offer a much-needed overhaul of the current system for the regulation of mortgage brokers, as well as enhance protections for consumers by subjecting mortgage brokers to background checks, educational testing and possible enforcement actions.
He said that theres a move for a comprehensive database of state-licensed originators that consumers could actually access. This would help consumers have a comprehensive listing of mortgage lenders and brokers so that they will know if a particular lender or broker has a disciplinary history, Taft said.
He mentioned that also included in the housing bill are changes to the disclosure and statutory damages provision of the Truth in Lending Act. These changeswill require lendersto offer all borrowers early discolosure about the terms of their mortgage loan at least seven days before the closing, among other things.
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