ByJames Hamilton

The graph below plots what some of us see as a key factor in the economic problems that the U.S. has been experiencing over the last four years. Household mortgage debt grew 60% faster than income between 2000 and 2007, and we may not see a return to a healthy economy until that ratio returns to more typical historical values. That could come from a combination of (1) foreclosures– a painful process with significant deadweight loss for all parties–, (2) higher saving rates– which make it harder to realize short-term growth in total spending– or (3) strong GDP growth– which is hard to achieve given (1) and (2).

Mortgage debt as a percent of GDP. Calculated as one hundred times the level of home mortgage debt (taken from Flow of Funds, Table B100, row 33) divided by nominal GDP (taken from Bureau of Economic Analysis, Table 1.1.5).

Another way that the debt burden could be reduced is through refinancing. Often U.S. fixed-rate mortgages allow the borrower the option to pay off the loan if interest rates decline, replacing it with a new loan based on a lower interest rate. For the borrower, that means either lower monthly interest payments or a loan that gets paid off more quickly. Although under the FHFA proposal the household would owe the same notional amount as before, the real burden of the debt on the household is lower, and the household is clearly better off, if it can refinance the loan at a lower rate. The household’s gain is naturally the loss of the party who was set to receive the original mortgage payments. If the lender receives a lump-sum payment of the full principal today, they could not use it to purchase an asset with as high a monthly income stream as the payments promised under the original mortgage.

One obstacle to refinancing has been mortgages that are underwater, which means that, as a result of declines in house prices since the time of the purchase, the principal owed on the mortgage exceeds the current resale value of the home. Previous rules would not allow Fannie or Freddie to guarantee a loan whose value exceeds that of the home, which refinancing an underwater loan would require. The new FHFA proposal relaxes that requirement so as to allow refinancing for underwater loans that were originated more than 2-1/2 years ago and on which the borrower is current on the payments with no late payments over the last 6 months.

One question of interest is, who will ultimately end up losing the income that corresponds to the household’s gain from refinancing? Since the original loans are currently guaranteed by Fannie or Freddie, and since Fannie and Freddie’s liabilities in turn are now de facto guaranteed by the U.S. Treasury, one’s first thought might be that the household’s gain is ultimately the loss of the U.S. Treasury. However, Fannie and Freddie guarantee against default but not against the loss that comes from pre-payment, so it’s the holder of the loan, not the U.S. Treasury, that loses. On the other hand, Fannie and Freddie own over a trillion dollars of the loans themselves, and the Federal Reserve owns another trillion. The Federal Reserve contributed $82 billion to the U.S. Treasury this year from its earnings on the mortgage-backed securities and other assets that it holds. A lower income flow from these would reduce the size of the payments to the Treasury that the Fed is able to make and increase the net contribution the Treasury needs to make to keep Fannie and Freddie solvent.

Other holders of agency-guaranteed loans include U.S. commercial banks, institutions outside the U.S., mutual funds, retirement funds, and state and local governments.

In terms of the agencies’ default guarantees, they currently have partial recourse in terms of representations and warranties issued by the originators of the loans. The new proposal is to waive these for the refinanced loans, which in principle gives the government exposure to a little more of the default risk than it had before. Here is the FHFA’s analysis of this concern:

Nearly all HARP-eligible borrowers have been paying their mortgages for more than three years, and most of those for four or more years. These are seasoned loans made to borrowers who have demonstrated a capacity and commitment to make good on their mortgage obligation through a period of severe economic stress and house price declines.

The program would only be available to households that have been making their loan payments, despite being underwater. These are people who want to pay what they owe and are trying their best to do so. Insofar as refinancing makes those payments easier, one would expect the refinanced loans to exhibit lower default rates than would be observed if refinancing is not allowed.

My conclusion is that the direct consequences of the proposal potentially may entail a modest adverse budget impact, but that indirect benefits to the overall economy and perhaps even to the Treasury as well outweigh these. The proposed modification of HARP looks to me like a reasonable plan.