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September 24, 2012

How Much Can Refinancing Reduce the Risk of Mortgage Defaults?

Joshua Abel, Joseph Tracy, and Joshua Wright

Improving the ability of homeowners to take advantage of prevailing low mortgage rates by refinancing has remained an active topic of discussion. In a speech in January, New York Fed President Bill Dudley advocated for efforts “to see refinancing made more broadly available on a streamlined basis and with moderate fees to all prime conforming borrowers who are current on their payments.” In an earlier post, we argued that such a refinancing program would not represent a zero sum game between borrowers and investors; rather, it would yield net macroeconomic benefits.

    In this post, we argue, based on new research from 2012, that an additional benefit would be a lower risk of default for households that refinance their mortgages. This would result in savings for taxpayers, who are exposed to the credit losses by Fannie Mae and Freddie Mac. Our research uses the novel approach of investigating the impact of refinancing by studying payment reductions in adjustable-rate mortgages (ARMs). While ARMs are significantly less common than fixed-rate mortgages and differ in some ways, this methodology provides some advantages for estimating the impact of refinancing on fixed-rate borrowers, which is a difficult topic to address for several reasons.

    An earlier effort in 2009 to analyze the effect of refinancing on credit loss relied on loan modification data, because a refinancing is similar in many regards to a loan modification, in which the interest rate is reduced and the loan term is extended. When conducting this type of analysis, it is critical to control as well as possible for other factors that may influence default behavior in order to isolate the impact of the lower monthly mortgage payments. Since loan modifications have targeted borrowers who are already seriously delinquent, the earlier study estimated the degree to which lower monthly payments reduced the likelihood that the borrower would redefault on the mortgage (borrowers are brought back to being current as of the modification date). The study found that for a sample of modifications to securitized subprime mortgages, a 10 percent reduction in the monthly payment was associated with a 4.5 percentage point reduction in the twelve-month redefault rate (defined as a mortgage going ninety days delinquent).

    While these findings suggest that improving the government’s Home Affordable Refinance Program (HARP)—as we discuss below—might also lead to lower future defaults, a couple of important considerations would point to caution in drawing this conclusion. First, the 2009 results are confined to subprime borrowers, while HARP involves prime borrowers with much stronger credit profiles at the time they took out their mortgages. Second, the modifications studied in our 2009 New York Fed staff report were given to borrowers who were already seriously delinquent, but HARP requires a borrower to be current in his or her payments and to have a relatively clean payment history over the prior year. The differences between the borrower populations and their circumstances are significant enough to warrant caution in assuming that the results from these earlier subprime modifications would carry over to an improved HARP.

    To date, HARP has resulted in just over a million households refinancing their mortgages. The ideal study would link together the prior mortgage with the HARP-refinanced mortgage so that one could measure the percent reduction in the monthly payment and estimate how HARP impacts the likelihood that the borrower will default on the refinanced mortgage. With such a linked HARP mortgage data set, one could control for other important factors, such as the borrower’s updated loan-to-value (LTV) ratio, when estimating the impact of the payment change on the default risk. However, no such linked data set on HARP-refinanced mortgages exists, making it difficult to estimate the effect of lower monthly payments on the population of HARP-eligible borrowers.

    An alternative approach that is possible with existing data is to examine the default behavior for prime adjustable-rate mortgages. By focusing on prime ARMs, we’re comparing similar borrowers in terms of their credit profiles at the time they took our their mortgages. As accommodative monetary policy helped to push down mortgage rates over the past several years, the rate resets on many ARMs resulted in lower monthly mortgage payments. The percent reduction in the mortgage payment from the origination date to the most recent rate reset date can be used to help explain subsequent default behavior by the borrower. This approach also addresses the second concern raised above, that there’s no precondition that borrowers be seriously delinquent in order for the rate resets to reduce their monthly mortgage payments.

    In our new research, we examine a sample of over 173,000 prime ARMs originated since 2003. In total, we have over 6.5 million monthly observations on these mortgages. We control for a number of other factors that may determine a borrower’s default risk (again measured as a borrower becoming ninety days delinquent), including the origination credit (FICO) score, the updated LTV, the local unemployment rate, and the prior twelve-month change in house prices. Focusing on borrowers with an updated LTV of 80 or higher who would be candidates for refinancing under the HARP program, we find that a 26 percent reduction in the monthly mortgage payment (our estimate of the average reduction for a HARP refinancing) would result in a 3.8 percentage point reduction in the five-year cumulative default rate. Combining this with an estimate of the likely losses given a default on these mortgages, our results indicate that borrowers who refinance under HARP have an estimated reduction in projected credit losses of 134 basis points. This implies that for every billion dollars in agency mortgage balances that refinance through an improved HARP, the estimated reduction in credit losses would be $13.4 million. This reduction would primarily benefit taxpayers, although private insurers of the underlying mortgages would also receive some benefit. Again, these reductions in defaults are in addition to the macroeconomic benefits we described in our earlier post.

    In October 2011, the Federal Housing Finance Administration announced enhancements to the HARP program designed to increase its effectiveness. These changes included extending the deadline, eliminating the LTV cap of 125, and lowering the fees involved in a HARP refinancing. The merits of further program enhancements are the subject of current debate. As we argue in a prior post and this post, improving HARP will provide benefits to the economy by increasing the disposable income to households that refinance and saving taxpayers money by reducing credit losses by Fannie Mae and Freddie Mac.



Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.




Abel_joshua_color
Joshua Abel is a research associate in the Research and Statistics Group of the Federal Reserve Bank of New York.


Tracy_joseph_color
Joseph Tracy is an executive vice president and senior advisor to the Bank president at the Federal Reserve Bank of New York.


Wright_joshua_color
Joshua Wright is a policy and market analysis associate in the Markets Group of the Federal Reserve Bank of New York.
Posted by Blog Author at 07:00:00 AM in Housing
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The Home Affordable Refinance Program (HARP) is specifically targeted at borrowers who have demonstrated an ability and willingness to service their mortgages, but who would have difficulty refinancing since they do not currently have enough equity to make a 20 percent down-payment on a new mortgage (and whose loans are guaranteed by Fannie or Freddie) or face other obstacles to refinancing (http://www.fhfa.gov/webfiles/24140/Jun-12_Refinance_Report.pdf). This, of course, includes many “underwater” borrowers. Since the start of the program, 17 percent of HARP refinances went to borrowers who were in negative equity by at least 5 percent (that is, their loan-to-value, or LTV, ratio exceeded 105). As the program has been revised, though, here has been an increase in HARP refinances by underwater borrowers: This year, 37 percent of HARP refinances went to borrowers with an LTV of 105 or higher. Our research shows that the HARP program, by allowing borrowers to refinance who otherwise would not be able to, will reduce the expected default rate for these borrowers and the associated credit losses to Fannie and Freddie. As such, this does help to mitigate the effects of the housing crisis.

If a borrower can refinance, then it can be assumed they are not underwater on on their loan, and it can also be assumed then that under financial duress, they could likely make the bank whole and retain creditworthiness by selling, and moving into less expensive housing.

That refinancing is an indicator of fewer defaults at the margin is unsurprising, but but it is also not material in reducing the effects of the current crisis.

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