Paper Suggests Lower GSE Fees May Pay Off in Reduced Defaults

The Federal Reserve Bank of New Yorkrnrecently released a paper that looked at the impact of HARP revisions on loanrndefaults and pricing.  The paper, Payment Changes and Default Risk: the Impactrnof Refinancing on Expected Credit Losses was written by Joseph Tracy andrnJoshua Wright.  </p

When the Home Affordable Refinance Programrn(HARP) was initiated, its goal to stimulate the economy and reducing defaultsrnby lowering mortgage payments in households with high loan-to-value mortgages. Thesernwere borrowers who were otherwise unable to refinance. </p

HARP was implemented in 2009 but refinancingrnactivity was much lower than expected. rnJust over one million refinances have been done under HARP rather thanrnthe 3 to 4 million expected.  Thisrnconfirms, the authors say, the original rationale for HARP, that in the wake ofrnthe housing bust borrowers need help refinancing.</p

HARPS lackluster results have provoked discussionrnabout the impediments to refinancing including credit risk fees, limited lenderrncapacity, a costly and time consuming appraisal process, limitations onrnmarketing, and legal risks for lenders.  HARPrnwas recently revised to better address these impediments. .</p

Concerns about revising HARP includedrndoubts about its fairness and about macroeconomic efficiency.  The Federal Housing Finance Agency (FHFA) hasrna responsibility to weigh the value of any proposed changes in terms of a possiblernimpact on the capital of the government sponsored enterprises (GSEs).  These could include a reduction in the incomerngenerated through interest on the GSE’s Holdings of MBS, on the expectedrnrevenues from the put-backs of guaranteed mortgages that default, and finallyrnon the impact of refinancing on expected credit losses to the GSE fees.  </p

One outcome of an improved program wouldrnbe more borrowers in a position to refinance. rnEstimates can be made of the average reduction in monthly mortgagernpayments that would result from a refinance; the question is how this paymentrnreduction would affect future defaults. rnIdeally a study could determine the difference in expected credit lossesrnfrom two identical borrowers with identical mortgages where one borrowerrnrefinances and the other does not.  However,rnonce the existing mortgage is refinanced it disappears so bothrnmortgage/borrower sets cannot be similarly tracked and the impact of thernpayment change on a borrower’s performance must be inferred.</p

A recent congressional budget officernworking paper estimates that reduced credit losses would produce an incrementalrn2.9 million refinances of agency and FHA mortgages and that such a programrnwould reduce expected foreclosures by 111,000 or 38 per 1000 refinances,rnreducing credit losses by $3.9 billion.</p

Using data from Lender ProcessingrnServices the authors selected eligible borrowers from among borrowers who hadrnbeen current on mortgage payments for at least 12 months and had estimated loan-to-valuernratios (LTV) over 80 percent. To measure motivation the authors selected loansrnwhere the borrower could recover refinancing costs in two years.  Using these parameters it was determined thatrnrefinancing would reduce the required monthly payment by 26 percent on average.</p

The authors found impacts on resultsrnfrom various combinations of local factors such as house prices, employmentrnrates, the local legal methods of handling delinquencies, and contagion risk,rni.e. the exposure of the borrower to others who had defaulted.  There were also effects from FICO scores andrndebt to income ratios and loan specific factors such as the purpose of thernloan, full documentation of the loan, and length of loan term.  Various methods were used to control forrnthese variables including excluding loans from the sample.</p

It is acknowledged that LTV ratios haverna significant correlation with default and the authors did test and confirmrnthis relationship.   The next step was to estimate the impact of arn26 percent payment reduction on the average default rate.  The authors used estimated ARM default andrnprepayment hazards to do a five-year cumulative default forecast holding thernlocal employment rate and home prices stable. rnAt five years the models imply that the expected cumulative default raternwould be 17.3 percent. When the payments are reduced by 26 percent the expectedrndefault rate is reduced to 13 percent a 24.8 percent reduction.   The same analysis was run for borrowers withrnprime conforming fixed-rate mortgages obtaining a cumulative default rate ofrn15.2 percent which refinancing reduced to 11.4 percent, a decline of 3.8rnpercentage points.  </p

These figures were used to conduct arnsimple pricing exercise to measure the difference between a refinancing feernthat maximizes fee income for a certain category of borrowers and a fee thatrnmaximizes the combination of the fee income and the reduction in the expectedrnfuture credit losses using the GSE pricing categories for their loan level adjustments.  It was found that FICO score strongly impactedrnboth payment reductions and default rates ultimately resulting in reductions inrnthe default rate of 1.9 percentage points for a high FICO borrower and 9.1rnpoints for a low one.  This implies thatrnincorporating the impact of expected credit losses into the pricing decisionrnshould generate higher price discounts for weaker credit borrowers as measuredrnby FICO score and LTV.</p

The authors found that incorporating thernimpact of expected credit losses after refinancing on average lowed the desiredrnpricing by 17 basis points.  Looking atrnthe averages by LTV intervals shows an impact of 15 basis points for mortgagesrnwith a current LTV of 80 to 85 and increases to 14 basis points for mortgagesrnwith a current LTV of 105 or higher. rnBasing fees on FICO scores involves a much more complicated set ofrnfactors.  </p

The authors conclude that the averagernHARP refinance would result in an estimated 3.8 percent lower defaultrnrate.  Assuming a conservative averagernloss-given default of 35.2 this indicates an expected reduction in futurerncredit losses of 134 basis points of a refinanced loan’s balance. </p

The paper concludes that the impactrnof refinancing on future default risk is important to the current debate of thernGSE fee structure for HARP loans.  “Thesernresults suggest that refinancing can be fruitfully employed as a tool for lossrnmitigation by investors and lenders.  Thernoptimal refinance fee will be lower if this reduction in credit losses isrnrecognized.”  Reducing fees, the authorsrnsay, will increase incentives to refinance but at the cost of fee income to thernGSEs.  “Our analysis shows, however, thatrnthere is an offset to this lower fee income today which is lower credit lossesrnin the future.”

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