The Mortgage Refinancing Catch-22

Although mortgage rates are extremely low, most existing homeowners are not able to take advantage of them due to stricter standards and reduced equity. Because the borrowers who are able to refinance tend to be the best qualified and least likely to be in trouble, many homeowners who currently have ARM loans will not be able to refinance as rates go up and will default as their payments become unaffordable. See the following post from Expected Returns.

The government has been active in purchasing agency debt and artificially pushing 30-year mortgage rates to 5%. For the 1 in 4 Americans who are underwater on their homes, this should be good news. Unfortunately, very few are able to refinance and benefit from low mortgage rates. From the WSJ, Borrowers Miss out on Billions in Savings:
The Federal Reserve has pushed mortgage rates to near half-century lows, but millions of U.S. homeowners haven't benefited from that because they can't—or won't—refinance.

Falling home prices have left many owners with little or no equity, making it harder to qualify for refinancing. Moreover, stricter lending standards and higher fees by banks and mortgage giants Fannie Mae and Freddie Mac and declining incomes have made it tougher and less attractive for borrowers to seek new loans.
The government has done pretty much everything to bail out speculators, at taxpayers' expense, who gambled on homes that supposedly never go down in value. The bail outs obviously are having very little direct effect on the housing market. Existing homeowners are unable to refinance at low rates, and as I mentioned recently, new home sales are cratering.

Keep in mind that new and existing home sales tend to rise and fall together in close correlation. However, we are now seeing a growing disconnect between new and existing home sales, which strongly suggests that existing home "sales" are of the distressed kind. This is why home prices are coming under pressure even with massive government intervention.
The last time mortgage rates were at current levels, in 2003, refinancing activity hit $2.9 trillion, according to trade publication Inside Mortgage Finance. Last year, refinance volume reached $1.2 trillion, the highest amount since 2003 but not nearly as much as expected, considering how low interest rates have fallen.

Traditionally, borrowers have an incentive to refinance when they can reduce their mortgage rate by one percentage point or more.

Borrowers who are refinancing tend to be those who need it least. Fannie and Freddie refinanced 4.2 million borrowers last year. On average, borrowers who refinanced through Freddie Mac saved $2,600 annually. But the savings on the whole have gone to "very, very good credit borrowers and it really isn't going very far down the credit spectrum," said Michael Fratantoni, the head of research and economics for the MBA.
Since refinancing is being extended to only the most prudent borrowers, the housing crisis, which is a product of the imprudent, will move ahead on schedule. It should be clear at this point that banks won't extend credit in an environment they still perceive to be weak.

Understand that this is a very tenuous situation. There are a wave of option ARM resets coming due, and I suspect many homeowners are counting their lucky stars since their option ARMS are resetting at a low rate.

Once mortgage rates start rising, there will be a mad rush to refinance and lock in low rates. Expect these homeowners to be blocked from these attempts, which will force them to foreclose as their mortgage payments rise exponentially.

The following chart showing the wave of resetting loans suggests that the next 2 years will be very challenging for housing.

Homeowners got way too overleveraged for this crisis to be cured by lower mortgage rates alone. In reality, the only cure for lower prices, are lower prices. The government must allow people to default so we can clean up all the bad debt from the system and transfer ownership of homes from weak to strong hands. This is the only logical thing to do, and the only thing that has worked historically.

Instead, we are creating zombie banks and a weak credit environment, which translates to a weak economic environment.

This post has been republished from Moses Kim's blog, Expected Returns.



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