Professor Cole's Finance Blog

Today, the Wall Street Journal published an article on the dismal failure of the Obama administration's Home Affordable Refinance Program.  The administration’s response to the housing crisis has been to trot out a set of ill-conceived programs formulated by advocates rather than practitioners or scholars. Now, four months have passed, during which more than 500,000 homeowners have fallen delinquent on their mortgages IN EACH MONTH, including 564,000 during July (Source: Lender Processing Services). The percentage of mortgages either delinquent or in foreclosure has risen from 10.4% in March to 11.56% in July. Why has the administration’s housing relief program failed so miserably?

The answer lies in the poorly conceived programs put out by the administration. The policy wonks who devised these programs appear to have been blissfully unaware of how the mortgage market works and how bad the housing situation had deteriorated.

These wonks failed to address the fact that the majority of troubled borrowers couldn’t put down a 20% down payment and, therefore, took out second mortgages equal to 20% or more of the primary loan balance. When the borrower attempts to refinance the first mortgage, she must either refinance the second mortgage or get the holder of the second lien to “subordinate” its claim to that of the new first-lien holder. Most of these second liens are practically worthless on a market- value basis, so the second-lien holders view this as an opportunity to force repayment of their claim, and refuse subordination.

The wonks also appear to have been unaware of complications posed by insurance purchased by some lenders to deal with requirements of Fannie and Freddie on high LTV mortgages. By refinancing these mortgages, the original lenders would lose the protection afforded by the insurance for which they had already paid.

The wonks originally targeted the HARP program at borrowers who owed between 80% and 105% of their home’s current appraised value. This knocked out millions of borrowers who were and/or are now underwater by more than 5%, for better or for worse. (Refinancing these loans without principal reduction is a recipe for future delinquencies.)

Adding to the comedy of errors was the administration’s failure to harmonize this program with the Fed’s program to temporarily push down mortgage rates, which was quite successful during April and May, but more recently has faltered in the face of the administration’s massive and rising deficits.

Home equity is the seed capital for small businesses and small businesses are responsible for the vast majority of new jobs (source: SBA). There is a vicious feedback effect where rising unemployment leads to deterioration in the housing market, which, in turn, contributes to rising unemployment. Until this feedback cycle is broken, unemployment will continue to rise, housing values will continue to fall and budget deficits at both the state and federal levels will continue to balloon. 

For an alternative plan, see my Housing Asset Relief Program, which I first posted to SSRN in early February and circulated to policymakers shortly thereafter. An abbreviated version of this program was published as an Op-Ed in the Financial Times on April 21, 2009.