WORD ON THE STREET: The reason that the recent efforts at quantitative easing by the Federal Reserve have not had the expected results, and will continue to have very limited results at best, is the lack of coordination between the Congress and the Federal Reserve in their policy direction. While the Federal Reserve has supported a policy of quantitative easing, the politicians have conducted a policy of qualitative tightening at the microeconomic level through increased government regulation, tougher accounting standards and stricter lending requirements.Â
Tighter credit and larger equity, income and assets requirements in mortgage lending have heavily negated the benefits of lower interest rates. More stringent accounting and auditing standards have also made financial institutions focus more on capital ratios than on lending activity.
The current economic situation will not correct itself until policies regarding qualitative easing at the microeconomic level support those quantitative-easing policies that have already been implemented. The following are three steps that the federal government needs to take in order to allow more qualitative easing.
First, mortgages need to be priced to 10-year Treasuries. Now that Fannie Mae and Freddie Mac are held in conservatorship by the federal government, the U.S. Treasury is essentially the issuer of mortgage-backed securities (MBS) and guarantee their performance, much in the same way that they do Treasury securities.
The prepayment speed of a 30-year mortgage has historically averaged less than 10 years, as individuals have, in the past, refinanced their loans or sold their residences prior to loan maturity. With an average life of 10 years, the yield for a mortgage should be based on a 10-year Treasury security.Â
As of Oct. 29, the yield for a 10-year Treasury is approximately 2.61%, with the average yield for an MBS approximately 150 basis points (bps) higher. Since the likelihood of performance, or credit risk, to an investor of a Treasury security and MBS are now the same, there is no reason why 30-year fixed-rate mortgages shouldn't be priced at a rate comparable to a 10-year Treasury security.Â
The government could, in effect, purchase all of the mortgage securities and sell 10-year Treasuries in their place, as the credit risk to the government would be the same. An additional 25-bps adjustment to yield could be applied, with a portion of this fee used as a reserve to offset potential loan losses. Even with an additional 0.50% (including the 25-bps fee) added to the rate, this would result in 30-year mortgage rates of 3.11% versus the current rate of 4.125% – a 1.5% improvement over what is currently available to current or potential homeowners.
In 2006, there were over $6 trillion of MBS issued and outstanding. Every 1% decline that can be made in mortgage rates through refinancing those securities will give homeowners an additional $60 billion in annual disposable income. By reducing mortgage payments, housing becomes more affordable to current homeowners, reducing foreclosure risk and allowing individuals to sell their homes at a time that may be more advantageous to them, thus reducing the current housing supply.Â
Mortgage rate reduction also increases demand for housing by making homeownership more affordable for more individuals. An increase in housing demand combined with a decline in housing supply results in increased home prices.
Second, a new mortgage refinance program needs to be offered. Higher credit-score requirements and greater down-payment, income and asset requirements have resulted in artificially reduced the demand for housing by acting as a barrier to entry for those who are not ‘highly qualified.’
Declines in housing values have also led those who may qualify for a mortgage refinance from a credit perspective to be forced to support a higher mortgage rate, because they have insufficient equity in their homes. A new ‘Mortgage Only’ streamline refinance program needs to be introduced by Fannie Mae and Freddie Mac. Borrowers will qualify if a) they have been current on their mortgage(s) over the most recent 12 months, and b) their new mortgage payment is lower than their old mortgage payment, which would include the old payment on any subordinate lien also being refinanced into the new loan.Â
The program would ignore income, employment, assets, occupancy, existing loan type, loan amount or credit other than mortgage payment history and, most importantly, property value. Homeowners would be allowed to roll all closing costs into the new loan, along with any existing second trusts or other subordinate liens, regardless of the age or use of those liens. There would be no limit on the loan size so that all mortgage liens could be included in the new loan amount and borrowers would be able to take advantage of the lower rates. If these loans are securitized in a manner indicated under the first item, the credit risk to the end investor would remain unchanged.
The theory behind such a program is simple; an individual capable of making his or her current payment should be able to make his or her new, lower payment. This would potentially lower current housing payments, increase disposable income and potentially delay foreclosures, allowing homeowners the ability to sell their homes at a time more advantageous to them, thus reducing current housing supplies. Reductions in housing supply should improve demand for the remaining supply and help stabilize or improve housing values. Improved housing values will allow individuals who are unable to afford their homes options other than foreclosure.Â
The refinancing of a significant portion of the outstanding mortgages would also aid the financial stability of most banks, insurance companies and financial institutions by allowing existing assets that may be deeply discounted in value (or, in the case of second trust mortgages, possibly valued at zero) to be paid off, increasing the profitability and improving the balance sheet of the institution, being paid off. An increase in profitability and the net worth of a bank or financial institution combined with the payoff of its existing assets would increase their net capital ratio and improve their overall liquidity, allowing them to be more aggressive lenders.
Third, we need to consider modifying the existing fair market value, or mark-to-market rules. In my opinion, these rules were created to prevent banks and financial institutions from holding nonperforming assets on their books at overinflated values. As with most well-intentioned plans, its application to all loans, as opposed to not just those that are nonperforming, has resulted in a serious deterioration in the value of most loans and mortgage-related securities being held by banks and financial institutions today.
The existing rules do not need to be eliminated, just modified. Banks are more concerned with shrinking their asset size in order to improve their capital ratio than with lending.Â The government needs to recognize that most loans that were not originated to agency guidelines will not be properly valued in today's market – no matter how likely it is that the loan will perform – and allow banks and financial institutions to hold performing loans on their books at the lower of their acquisition cost or par value, applying the current mark-to-market rule to nonperforming loans where the application of the rule makes the most sense.Â
By doing so, every bank and financial institution that currently owns a performing loan will see an immediate improvement in its balance sheet, which will improve its capital ratio and thereby give the bank greater incentive to start lending again. This no-cost minor adjustment in a flawed accounting rule will have a far greater impact on correcting the current economic situation than taxpayers' billions of dollars ever will.
Few individuals will deny that the artificial increase in housing demand created by the advent of the alternative documentation programs introduced earlier this decade led to the hyper-inflated and unsustainable housing values that were experienced. While I am not condoning a return to those excesses, it is my belief that the implementation of these three steps, in conjunction with the proposed quantitative-easing policies, will be the catalyst for bringing this country back to economic recovery.
John G. Mortimer is senior vice president of Acacia Federal Savings Bank, based in Falls Church, Va. He can be reached at (703) 506-8156.