Most of the small print about the Administration’s plan to help beleaguered mortgage borrowers is now available at www.makinghomeaffordable.gov. In my view, it is coherent and well-thought out, but disappointing in its limited scope. The program is designed to provide benefits to owners who deserve to be helped, rather than to reduce foreclosures and stabilize home prices.

The program name is "Making Home Affordable", henceforth MHA, and it has two parts. Part one is directed toward increasing refinance opportunities for borrowers whose loans are owned or guaranteed by Fannie Mae or Freddie Mac, and who don’t have more than 5% negative equity on their first mortgage. Borrowers with negative equity greater than 5% don’t qualify.

The second part of the program encourages payment-reducing contract modifications of mortgages that are endangered by adverse events affecting the borrower – such as a job loss or a pending rate increase. The major tool for reducing the payment is rate reduction, with balance reductions only a last resort. Borrowers with investment properties don’t qualify.

The limited scope of the program is why its cost is estimated at only $75 billion, or less than the amount required to bail out AIG. The systemic impact will be correspondingly small.

Failure to Attack Negative Equity

The major limitation of the program is that it does not attack the problem of negative equity – mortgage balances larger than the value of the homes securing the mortgages. Large and growing negative equity underlies the sharply reduced values of mortgages and mortgage-related assets on the books of the financial institutions holding them. These reductions in asset values have eroded the capital of these institutions, which the Government in case after case has had to replenish to prevent failures.

The new program is focused entirely on the capacity of borrowers to make their monthly payments. Indeed, this is evident from the program name, "Making Home Affordable". The major tool for reducing the payment is rate reduction, with balance reductions only a last resort in cases where rate reduction and term extension can’t get the payment low enough to be affordable.

This approach flies in the face of evidence that balance reductions are critically important in avoiding subsequent redefaults. A recent study by Roberto G. Quercia, Lei Ding and Janneke Ratcliffe, found that "Among the different types of modifications, the principal forgiveness modification [ie, balance reductions] has the lowest redefault rate. We believe that this is because it addresses both the short-term issue of mortgage payment affordability and the longer-term problem of negative equity…The results indicate that households with negative home equity are more likely to redefault over time, even when a modification has initially lowered the mortgage payment." [Loan Modifications and Redefault Risk, Center For Community Capital Working Paper, March 2009].

Mindset Underlying the Neglect of Negative Equity

A different mindset is applied to helping borrowers as opposed to helping financial firms. Firms are helped in order to avoid the systemic consequences of the firm’s failure. Whether or not the firm "deserves" to be helped is wholly irrelevant. Indeed, it could be argued that the largest bailouts have been directed to the least-deserving firms. This is unfortunate but unavoidable because it is the system that is as stake.

When it comes to assisting mortgage borrowers, however, the mindset is that assistance should be limited to those who have some moral claim to Government assistance. Eligibility is based on deservedness, with the systemic implications swept aside.

In the minds of the program’s designers, having negative equity is not an indicator of deservedness. True, most negative equity has arisen from broad price declines affecting entire markets, but borrowers are not altogether blameless. They could have made larger down payments when they bought the house, and they certainly did not have to take out that second mortgage that allowed them to live (temporarily) beyond their means.

This same mindset is evident in the rule, incorporated in both programs, that only occupants are eligible. Investors -- those who rent their properties rather than occupy them -- are not eligible. In this mindset, investors don’t deserve help because they were implicated in the bubble that preceded the crash, they bought houses in the hope of turning a quick profit, and Government should allow them to take their well-deserved lumps without interference.

I happen to agree with that sentiment, but in a financial crisis, deservedness considerations are an indulgence we can’t afford. The foreclosure of an investor-owned property puts the same downward pressure on home prices as the foreclosure of an owner-occupied property. Making investors ineligible because they aren’t deserving weakens the systemic impact of the program, which should be its major focus.

The Refinance Program

The refinance part of the program applies only to mortgages owned or guaranteed by Fannie Mae or Freddie Mac.

Purpose: The objective of the refinance program is to allow borrowers to refinance who otherwise find it impossible or excessively costly because of declines in the value of their properties. Under the program, loan balances can range up to 105% (later raised to 125%) of current property value, but in all other respects, borrowers must meet conventional underwriting requirements: their existing payments must be current, they cannot have more than one 30-day late payment in the previous 12 months, and their income must be sufficient to cover the new payments.

Pricing: Interest rates under the program are "market rates", but what that means exactly is hard to say. It is not clear, for example, whether the agencies will charge more for a 90% loan that does not have mortgage insurance than for one that does. Whatever it means, we can be sure that prices will fluctuate from day to day, and that the prices loan originators quote to borrowers will include varying markups and fees on top of the prices at which they sell to the agencies. Markups will be particularly high on loans held by Freddie Mac, which will only accept loans refinanced by the lender now servicing them.

Mortgage Insurance: An unusual feature of the program is that any mortgage insurance on the existing loan will be carried forward to the new loan. (Ordinarily, mortgage insurance is terminated when a loan is paid off and, if required, a new policy is issued on the new mortgage). The mortgage insurers have to agree to this arrangement, but since it is clearly in their interest, that should not be a problem.

This is a sensible idea, because it prevents a sudden drop in insurance premiums to the beleaguered mortgage insurers, and it also provides a way to comply with the rule that any loan acquired by Fannie or Freddie that exceeds 80% of property value carry mortgage insurance or its equivalent.

Rationale of the 105% Loan Cap: Capping the loan balance at 105% of value presumably is based on a judgment that borrowers with adequate income and a good payment record are not going to default just because they owe 5% more than their house is worth. That makes sense. What doesn’t make sense is that borrowers with more than 5% negative equity are not eligible for the refinance program at all, and can’t get their problem fixed by a loan modification under the second part of MHA (see below).

Eligibility: In its documentation, Treasury states that eligible borrowers must occupy their homes, a provision I criticized above. Interestingly, neither Fannie Mae nor Freddie Mac include this limitation in their requirements -- see  the table below -- contradicting the Treasury.

Eligible structures can have up to 4 dwelling units so long as the borrower lives in one of them.

The home can have a second mortgage, the balance of which is not counted in the 105% cap, but the second mortgage lender has to agree to remain in a second lien position. Some second mortgage lenders charge a fee for stepping aside, so this could pose a problem in some cases.

Borrowers are not allowed to withdraw cash from the transaction, even to pay off other debts. However, they are allowed to include settlement costs in the new loan balance.

The two agencies have gone their own ways in setting out eligibility rules, and there are many differences between them. One major difference is that Freddie Mac allows refinances only from the existing servicers whereas Fannie Mae will accept loans from any approved seller. On the other hand, Fannie Mae has many more fees than Freddie Mac. A complete list of the differences is shown in the table below.

By far the most questionable eligibility rule is the one that restricts the program to borrowers whose mortgages are held by the agencies or are in a security guaranteed by them. Borrowers had no control over which investor ended up with their loan, yet this crap shoot now separates those who are and those who are not eligible for the program. Is there a good reason for excluding the other half of the market?

Questionable Rationale For Limiting the Program: As noted above, the agencies must obtain mortgage insurance on any loan they purchase that exceeds 80% of property value. Their regulator, the Federal Housing Finance Agency (FHFA), has started that the agencies will be in compliance with this rule when they refinance loans they already own or guarantee because they are already responsible for any default losses on these loans, and the refinance does not increase that risk. This rationale would not apply to loans owned by other investors.

However, the agency would also be in compliance with the 80% rule if it purchased loans held by other investors that now carry mortgage insurance that the insurer has agreed to transfer to the refinanced loan. This is true as well of loans that originally met the 80% rule and still do. In a financial crisis, the net should be as wide as possible.

The Loan Modification Program

Like the refinance program, the loan modification part of MHA ignores negative equity and offers help only to owner-occupants. Investors are not eligible. Those negatives aside, the modification program is well designed. Its architects have taken note of a number of problems that have bedeviled existing modification programs, and have fashioned sensible remedies to deal with them.

Shortages of Trained Staff: The shortage of qualified staff by servicers, as well as the high cost of modifying loans, has resulted in many needless foreclosures that timely modifications could have prevented. The MHA remedy is to provide financial incentives to servicers to do more modifications.

Under the program, servicers are paid $1,000 for each eligible loan they modify, provided that the modified loan remains current through a trial period of at least 90 days. In addition, the servicer collects $1,000 a year for 3 years if the borrower stays current for that period.

High Incidence of Redefault: In the past, many borrowers with modified loans have subsequently defaulted. Many early modifications, however, did not reduce the borrower’s payment, and in some cases the payment increased.

Under MHA, the interest rate is reduced to a level where payments for principal, interest, taxes and insurance comprise no more than 31% of the borrower’s gross income. In addition, a borrower who stays current will receive $1,000 a year for up to 5 years in the form of balance reductions.

Restriction to Borrowers in Default: For the most part, servicers have limited modifications to borrowers who are two or more payments behind. This rule assured compliance with investor requirements that modifications were allowed only to avoid more costly foreclosures, and it also helped servicers allocate their limited staff to the most urgent situations. But it had the unfortunate effect of encouraging borrowers to default so they could get help.

The new program attempts to remedy this by establishing a "hardship" criteria for eligibility that does not require the borrower to be in default in order to qualify for a modification. In addition, bonuses of $1500 to the investor and $500 to the servicer are offered for each modification that is executed while the borrower facing hardship is still in good standing.

Multiplicity of Modification Standards: Different servicers have applied different standards to the modification process, both in terms of assessing eligibility and in establishing the type and scope of modification. The result has been vastly different treatment of borrowers, depending on who happened to be servicing their loan. The new program attempts to remedy this by setting out standards for determining eligibility, the type and amount of assistance provided, the documentation required, and other factors.

In brief, eligible borrowers must be able to document financial hardship, defined as a monthly housing expense (mortgage payment on the first mortgage plus taxes and insurance) in excess of 31% of gross income. If borrowers who qualify under this rule have a total expense ratio, which includes all other debt payments, of 55% or more, they must agree to obtain counseling. The mortgage payment of eligible borrowers is reduced to 31% primarily through temporary interest rate reductions, following procedures detailed by the Government.

Unfortunately, on modifications that are not MHA eligible, the multiplicity of standards will remain. Further, MHA rules do not supersede investor rules if there is a conflict between them.

The Second Mortgage Problem: Second mortgages are a potential barrier to modifying first mortgages because of the threat that the second mortgage lender can always foreclosure if the second mortgage payment is not made. Some servicers work with second mortgage lenders, while others require that the borrower make a deal with the second mortgage lender that gets them out of the way.

In the first phase of the program, Treasury stated that "incentives will be provided to extinguish junior liens on homes with first liens that are modified under the program". On April 28, 2009, they announced the details of such a program. In brief, the Government will share the cost of reducing the rate on seconds to 1% (2% on interest-only loans), or of extinguishing the second through a lump sum payment to the investor. The details are at Fact Sheet on Second Mortgages.

Home Affordable Conforming Loan Refinance Program: Key Distinctions between Fannie Mae and Freddie Mac

Source: Mortgage Bankers Association