Investment Services
Implications of the Homeowner Affordability and Stability Plan
The details of the Administration's Homeowner Affordability and Stability Plan were announced on March 4. Some of the details raise new questions and a few red flags, but we want to take a look at the general concept of the plan as a whole. Will this help, or is this just another in the long line of failed "solutions" to the housing problems? The plan consists of two parts.
The first part of the plan covers existing and performing mortgages issued by Fannie Mae and Freddie Mac (GSEs). Borrowers, still current on their mortgages, will be able to refinance up to 105 percent LTV in order to reduce the interest rates on their mortgages. The Administration estimates this will enable four to five million homeowners to refinance at lower rates that could not otherwise. While these mortgages are not currently considered at risk in terms of potential default, the refinancing can produce positive side effects for the housing market. First, although these borrowers might not currently be at risk of default, this will certainly lessen the likelihood that more borrowers will move into the at risk category. Second, borrowers will have improved monthly cash flows from the lower payments. While we cannot quantify its impact, this should have a positive affect on the overall economy. In the past, refinancing waves have led to increased consumer spending. While this is not a direct goal from the program, it should be a positive, unintended consequence.
The second part of the program is potentially more impactful, in terms of stemming the tide of foreclosures and stabilizing home prices. Under this plan, servicers and lenders will be encouraged to modify at risk mortgages, including non-GSE mortgages. Lenders will be required to reduce the interest rate on the loan to a point at which the borrower's gross income will cover 38 percent of the loan payment. The government will then match the lenders further rate reduction on a dollar for dollar basis in order to reduce the rate equivalent to a payment of 31 percent of gross income of the borrower. The Administration estimates this will save three to four million at risk mortgages.
Unlike previous mortgage programs, this proposal contains financial incentives to lenders and servicers to modify mortgages in default and adds incentives to modify mortgages still current but likely to default. The incentive is important in that not only does it provide an incentive for the original modification, it includes incentives for the first five years of the loan as long as it remains current. There is also an incentive to borrowers to stay current by reducing principal on the loan by $1,000 per year. For some borrowers significantly underwater, this will not be a significant incentive, but it will provide incentive to those in many parts of the country who are only modestly underwater.
The mortgages eligible under this plan will be restricted in size to the conforming limits of the GSEs, although these are non-agency mortgages. At first blush, this was thought to be a deterrent to the program's effectiveness in this area, but mortgage research shows that 90 percent of the universe of subprime mortgages and 50 percent to 60 percent of the universe of Alt-A and Prime mortgages conform to the size limitation.
The modification program will create consistent guidelines for loan modifications for the first time. We anticipate that the substance of the guidelines will be adopted by lenders and servicers for nearly all mortgage loans and borrowers, whether or not the borrower qualifies under the government subsidized modification guidelines. In this way, lenders and servicers can manage their entire population of borrowers in an efficient manner. It is conceivable that this will lead to modifications for an even greater number of borrowers with the associated benefits.
The wildcard in the proposal is the "cram down" feature. The proposal indicates that there will be some language that could either mandate or encourage involvement of bankruptcy courts in some cases. This could be a positive from the aspect of fewer foreclosures but a negative regarding losses to lenders and to investors. More details will be needed to ascertain the affect of this component of the proposal.
While $75 billion is being allocated to this plan, it is clear that the government may be willing to increase that amount should the program prove successful. This plan is clearly an improvement over previous efforts, but is it enough?
The short answer to this question is, no, or at least it is not a cure in and of itself. It's very clear that housing woes have gone far beyond financing of questionable or high-rate mortgages. Job losses and declining incomes are now at the root of the problem. But, if job losses abate in the second half of 2009, we can make some plausible assumptions on the plan's impact. Independent mortgage researchers vary greatly on estimates of foreclosures in the years 2009-2010. The range of estimates falls mostly between three million to a high estimate of eight million. Clearly, if the Administration's estimate of three million success stories is correct, this would have a significant impact. A more reasonable assumption would be a success rate of one and a half million to two million. If we assume that an estimate of a potential four million in foreclosures over the three-year period without a mortgage program is reasonable and a success rate of one and a half million to two million foreclosures with the plan, this would represent a significant improvement in the supply of homes on the market.
One unfortunate negative, however, is timing. This program will require time to implement. But we are likely to see extensions of moratoriums on foreclosures. More important, we need to look at what is happening now in distressed housing markets. What we are seeing now are signs that the housing market is making considerable strides toward "self-correcting." There are various measures of affordability used by analysts, but most agree that home prices have corrected back to normal historical ranges. John Burns Real Estate Consulting has traced affordability in various SMSAs using data for the past sixty years. His methodology incorporates incomes, interest rates, and prices. In early 2007 at the peak median home prices, his research indicated that home prices needed to fall by 35 percent to 40 percent in over-heated areas in order to return to the sixty-year trend line. (See chart below).
In most of those distressed areas, especially in Southern California, home prices have fallen 40 percent to 50 percent. The over-correction is to be expected after the extreme price increase. While home prices could have further to fall, affordability of homes is now a positive for the housing market instead of a negative.
Putting the affordability data aside, we can see how the decline in home prices is affecting buyers' behaviors. In the hard hit Inland Empire area of California, the number of homes sold during the past five months was more than double the pace of homes sold for the comparable months in 2007-2008. In the latest January data, home sales were the highest for any January since 2006. Investors have been extremely active in buying foreclosures. Given the amount of equity that must be invested in these homes, these are not homes that will be quickly put back on the market. First-time buyers have also been active as home ownership is finally attainable. Investors and buyers are aware that home prices might not rebound soon, but they have ascertained that prices now make economic sense. Realtors are reporting there is growing interest in those areas, and this is considered the slow season in real estate.
Given that most of the activity has been in foreclosures, there is little danger of a quick rebound in home prices. But we believe a realistic and sustainable price level for homes in distressed areas is being established. As long as this level of activity is maintained, we believe the bottoming in home prices has begun. Seasonally, real estate activity should increase in the next few months, and this would further establish current home prices as a base level. Price increases are not likely until more of the supply of vacant homes is absorbed, but we believe that fundamentals are in the process of improving even before the implementation of the Administration's plan.
Psychology plays a major part in home buying decisions. During the boom, headlines of soaring home prices likely caused many buyers to jump into the market although financially it was not a wise decision. Conversely, the negative headlines on foreclosures and year-over-year declines in home prices for the past year have likely led many qualified buyers to remain on the sidelines. However, as noted earlier, activity is beginning to pick up as buyers recognize that it makes financial sense to purchase a home based on the price declines that have already occurred. If moratoriums and the new plan do reduce the rate of foreclosures, as advertised, we believe this will encourage even more reluctant buyers to come off of the sidelines. Given the already steep declines of median home prices on a year-over-year basis, those year-over-year comparisons in the months ahead will come from much lower base prices. The headlines of "Home Prices Fall by 40 Percent Over One Year Ago" will fade away. Ready but unwilling buyers will likely be more inclined to act as negative foreclosure and home price headlines are replaced with headlines of moderation.
The Administration's plan is not a cure-all for the housing market. But there is a reasonable case to be made that with the self-correcting signs we are already seeing, the plan's impact will be the booster shot needed to stabilize the housing market in 2009.
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