Fed Study Points to Wisdom of Further HARP Enhancements

Economists have been debating thernvalue versus risk of expanded refinancing opportunities since the early days ofrnthe housing crisis. Proponents argue that refinancing would free up homeownerrnmoney for spending elsewhere to the benefit of the economy, opponents fear thatrnsince the Federal Housing Administration and the government sponsoredrnenterprises (GSEs) are realistically the only source of refinancing currentlyrnavailable, any risk inherent in refinancing will disproportionately fall therngovernment.  </p

To clarify an issue that is of interest tornhomeowners, policy makers, and taxpayers, the Federal Reserve Bank of New Yorkrnhas just published a report, Payment Changes and Default Risk:  The Impact of Refinancing on Expected CreditrnLosses by staff members JoshuarnAbel, Joseph Tracy, and Joshua Wrightrnthat looked at whether refinancing lowers the risk of default.<br /<br /Earlier studies have looked at defaults after loan modifications which reducernrates and/or payments.  One study foundrnthat for a sample of modifications to securitized subprime mortgages a 10rnpercent reduction in the monthly payment was associated with a 4.5 percentagernpoint reduction in the 12-month redefault rate. </p

Extrapolating earlier studies tornsuggest that expanding the government’s Home Affordable Refinance Program mightrnresult in lower defaults is suspect because the one study mentioned concernedrnonly subprime borrowers while HARP involves prime borrowers with much strongerrninitial credit profiles and those borrowers who were given modifications werernalready seriously delinquent while HARP requires homeowners to be current withrna relatively clean payment history over the previous 12 months.    </p

Thernideal study would link together the prior mortgage with the HARP-refinancedrnmortgage so that one could measure the percent reduction in the monthly paymentrnand estimate how HARP impacts the likelihood that the borrower will default onrnthe refinanced mortgage. With such a linked HARP mortgage data set, one couldrncontrol for other important factors, such as the borrower’s updatedrnloan-to-value (LTV) ratio, when estimating the impact of the payment change onrnthe default risk. However, no such linked data set on HARP-refinanced mortgagesrnexists, making it difficult to estimate the effect of lower monthly payments onrnthe population of HARP-eligible borrowers.<br /<br /The New York Fed study approached the issue by studying the impact ofrnrefinancing adjustable rate mortgages (ARMs). rnWhile these are significantly less common than fixed rate mortgages,rnthis methodology provided some advantages for estimating the impact ofrnrefinancing on fixed-rate borrowers such as allowing the researchers to comparernsimilar borrowers in terms of their credit profiles when their mortgages werernoriginated.  As rates have dropped, thernrate resets on many ARMS resulted in lower monthly mortgages payments, mimickingrnrefinances, and the percentage reduction in the mortgage payment fromrnorigination date to the most recent reset date can be used to help explainrnsubsequent default behavior by the borrower. rnThisrnapproach also addresses the issue of pre-existing delinquency raised by usingrnmortgage modifications in a study.</p

The authors used a sample of overrn173,000 prime ARMS originated since 2003 and on which there were an aggregaternof 6.5 million monthly payments and controlled for a number of factors thatrnmight affect a default rate such as the original FICO score, the updated LTV ratio,rnemployment data, and home price changes.</p

Focusingrnon borrowers with an updated LTV of 80 or higher who would be candidates forrnrefinancing under the HARP program, the authors found that a 26 percentrnreduction in the monthly mortgage payment, which they estimated would be thernaverage reduction through a HARP refinancing, would result in a 3.8 percentagernpoint reduction in the five-year cumulative default rate. Combining this withrnan estimate of the likely losses given a default on these mortgages, the resultsrnindicate that borrowers who refinance under HARP have an estimated reduction inrnprojected credit losses of 134 basis points, or for every billion dollars inrnagency mortgage balances that refinance through an improved HARP, the estimatedrnreduction in credit losses would be $134 million. This reduction wouldrnprimarily benefit taxpayers, although private insurers of the underlyingrnmortgages would also receive some benefit. </p<pThe authors note that enhancements such as removingrnthe previous 125 percent LTV ceiling were made to HARP last October and furtherrnenhancements are being debated.  Theyrnargue that improving HARP will provide benefits to the economy by increasingrnthe disposable income to households that refinance and saving taxpayers moneyrnby reducing credit losses by Fannie Mae and Freddie Mac.

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