Why This Mortgage Move Is a Bad Idea

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After years of falling home prices, the housing market has finally started to show some signs of life. But one idea that made the rounds last week would be a step in the wrong direction. Despite providing a quick shot in the arm for millions of homeowners, the benefits aren't enough to justify the cost -- and the long-term effects could be much more negative.

Housing and you
Millions of homeowners who bought homes during the housing boom still owe more in mortgage debt than their homes are worth. With all these underwater mortgages, these borrowers lack the home equity that gives other homeowners a bigger incentive to stay current on their mortgage payments. So-called "strategic defaults" have risen in popularity as many homeowners are willing to accept the big hit to their credit history that a foreclosure involves rather than trying to pay tens or even hundreds of thousands of dollars to make up the shortfall between the value of their homes and their outstanding loan debt.

But after half-hearted attempts to convince banks and other lending institutions to reduce the principal amounts due under mortgages -- attempts that have largely failed -- the federal government is now rumored to be considering more extreme measures. Reports last week suggested a new refinancing program that could cost as much $1 trillion over the next 10 years.

Because the talk at this point is almost entirely speculative, details are sketchy. But as a Bloomberg article set out the argument, a mass refinancing program could involve allowing anyone with a loan through a government sponsored enterprise like Fannie Mae or Freddie Mac to refinance their existing mortgages, reducing their interest rates to close to current levels around 4% for 30-year mortgages. Most important, the refinancing could happen without reappraisals or new income qualification -- making the transaction look more like a simple interest modification rather than a full-fledged refinancing.

Winners and losers
Obviously, such a program would have an immediate stimulative effect on the economy. Columbia economist Glenn Hubbard estimates that a whopping 72% of homeowners would be able to save an average of $355 per month on their mortgages at no cost to them, freeing up more than $85 billion for discretionary spending on other items. In addition, the effect in making the mortgage market more liquid would arguably help stem further price declines in housing.

In the corporate world, though, the program would have both winners and losers. Bank of America (NYSE: BAC  ) and Regions Financial (NYSE: RF  ) saw big gains last Thursday due to the rumored proposal, although the stocks both gave back ground after the Obama administration denied plans to implement such a program.

At the same time, mortgage REITs Invesco Mortgage Capital (NYSE: IVR  ) and Annaly Capital (NYSE: NLY  ) would likely see much of their interest margin evaporate with such a move, as they actually benefit from more illiquid conditions in the mortgage market as it provides them with better returns on the mortgage-backed securities that they own. The impact wouldn't be as high on Chimera Investment (NYSE: CIM  ) , however, as it focuses on non-agency mortgages that presumably wouldn't be included in any GSE-centered government refinancing program.

Ignoring the problem
The core mistake with such a program, however, is that it doesn't address the real problem: the fact that the mortgages are underwater. Although giving underwater homeowners a chance to refinance would obviously make it easier for them to afford to make future payments, they'll still lack the incentive to do so. Moreover, underwater loans will still keep it very difficult for homeowners to consider selling their homes, restricting movement and making it harder for people to move to where more promising jobs are.

In the end, any real solution to the housing problem has to address negative homeowner equity. The market is already taking its own steps to deal with the problem, as short-sales and other creative solutions seem to occur with more regularity. For the government to intervene in a way that doesn't seek to eliminate underwater mortgages directly risks unintended consequences that in the long run could do more harm than good.

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Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.

Fool contributor Dan Caplinger wishes that politicians would stop dancing around all the issues. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Bank of America, Chimera, and Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is always stimulating.

Read/Post Comments (13) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 09, 2012, at 11:46 AM, nofool22 wrote:

    Total bull – circular thinking – at the present time there is MORE incentive to leave their homes – with a lowering of interest rates there would be an incentive to keep their homes. They can not sell their underwater homes NOW – if there are more promising jobs the incentive to leave under present conditions is higher – with lower payments the incentive is to stay and keep payments up to date.

  • Report this Comment On January 09, 2012, at 12:22 PM, jpanspac wrote:

    This is strange logic, Dan. I agree with nofool22.

  • Report this Comment On January 09, 2012, at 1:06 PM, CMFKirk42 wrote:

    It's the same twisted logic that often comes out of various think tanks when talking about financial policy. The idea that the general public and small business owners see everything as pure financial transactions.

    They don't. Most home owners really don't care much if they are "under water". They care if they can make their payments or if they can sell if they need to in order to move.

    Lowering people's payments will reduce forclosure and people walking away. It will probably reduce short sales as well.

    All that said, I'm still pissed at that kind of plan. I bought and live in a cheap townhouse, pay well below my means, and have done everything "right", and now my tax dollars are once again going to help people who were stupid.

  • Report this Comment On January 09, 2012, at 1:08 PM, vaderblue wrote:

    All moves have pros and cons.

    Refinancing on a mass basis can have good effects though combine that with jobs and you

    would have a booming housing market and the domino effect of course would positve stimulus

    on the domestc economy as long as taxes do not increase. Good luck. Someone should go to Washinton and teach these wreckers of our economy what it takes to find prosperity for this nation.

    When you spend your life locked in the closet doors of the beltway you develope tunnel vision

    combined with inexperience in ecomonics and finance, Results, failing economy!.

    In the last three years recap your investments.

    Look at the volatiliy in the markets. Even the most experience investor has lost money. This is why we are even more selective - lack of direction from Washington, Does anyone have a genie.

    Still going long on dividends.

  • Report this Comment On January 09, 2012, at 2:03 PM, RaulChapin wrote:

    Here is a thought:

    In Canada, some student loans are as low or even lower than mortgages. Why is this? among other factors, the one that i believe is most important:

    After you declare bankrupcy... your student loan is still there waiting for you, ready to start being repaid.

    So unless you leave the country, you are stuck paying that no matter what.

    Giving homeowners the choice to:

    Refinance their home to a lower interest rate than currently paying.

    The debt is structured in two portions.

    The underwater portion Plus 20% of the current market price of the home, become the kind of debt that student loans are in Canada... they will be there waiting for you even if you declare bankrupcy.

    The other 80% of the current market price of the home, is a traditional mortgage.

    Why do i believe this might be a good idea:

    a) people who do not give a hoot... are going to default anyway, so they would not request to joing this program. But they could not really complain, as it is obvious that they are not willing to take the help.

    b) people who care about their credit rating, or even more importantly, people who have the moral conviction that they HAVE to pay that which they owe, would have a way to not lose their house and ruin their credit record.

    c) banks would be significantly stronger as very quickly their toxic mortgages would become traditional mortgages, plus a loan that is guaranteed never to be written off (save for the person never working again... which is rather unlikely in most cases)

    d) it brings back mobility. Knowing that you could move out of LA to get a job in Seattle, and that you can do this by getting a $40K loan (just to say something) makes sense if you think the other option is to stay in LA with no job and soon no house and no credit record.

    e) it would push prices to move up where there is work (and thus a higher price is justified by higher demand) and they would move down where there are no jobs.

    ... just pipe dreams... i do not beleive Mr. Obama will ever hear about this idea :)

  • Report this Comment On January 09, 2012, at 2:34 PM, gotoresfund wrote:

    "underwater loans will still keep it very difficult for homeowners to consider selling their homes, restricting movement and making it harder for people to move to where more promising jobs are" - with lower interest rates, I am seeing a new trend that is allowing people to relocate. Renting their primary home. It may not be ideal for people needing to relocate for a job etc, but refinancing their home loan with todays low rates (and HARP's 2.0 program), the lower payment is more in line with comparable rental payments, allowing homeowners to rent out their house and move on. I wrote about the effects of HARP 2.0 at New higher loan limits (unlimited by HARP?) could be a step in the right direction.

  • Report this Comment On January 09, 2012, at 3:38 PM, chopchop0 wrote:

    Outside of V, MA and NLY, I am not touching financials.

  • Report this Comment On January 09, 2012, at 8:23 PM, TMFGalagan wrote:

    @nofool22, @jpanspac -

    I understand the confusion, but think of it this way: all lowering an interest rate does is to put off the final day of reckoning. I'm arguing that on the whole, the economy's better off if the banks accept the inevitable and write off the shortfalls on those mortgages, rather than allowing government money to go toward stimulus-driven solutions that don't address clearing the backlog in the housing market.


    dan (TMF Galagan)

  • Report this Comment On January 10, 2012, at 9:02 AM, BMFPitt wrote:

    This would be an act of treason. Or in other words, business as usual for Congress.

  • Report this Comment On January 10, 2012, at 9:12 AM, TMFPennyWise wrote:

    The government's "Making Homes Affordable" programs (of which the 'HARP' plan is one every homeowner should know about) is a boon to homeowners everywhere and sounds like the refinance plan Dan describes in his lead article.

    The HARP refinance opportunity is already available to the public and the best features are most often no appraisal needed at all (unlimited upside-downness is just fine:), the banks will do investment homes/properties, and no income limitations (you can make a million a year and still qualify) an competitively low interest rates,. The mortgage does have to be owned by freddie mac or fannie mae and I think you have had to purchase your property prior to 2009. You can get more details at your lending institution or online. We have just done this on three properties we own with no problems.

    And you're right in your observation, gotoresfund, that it enables more flexibility for the owner to move, rent or hang on to the property. For us it gives us money saved to invest in our retirement.

    As for the comment about 'paying what's owed' for mortgagees, etc. above: that's a nice sentiment, but while the banks may want the underwater homeowner to think that it's the honorable thing to do to keep paying, many would say however that the ethical and smart thing to do would be to foreclose, mitigate your damages, and move on in a lesser state of financial disaster. After all, that is why the banks took your home as collateral as part of the contract.

    I think the HARP program and other "Making homes affordable" plans are a great idea and good for the economy too.

  • Report this Comment On January 10, 2012, at 1:32 PM, CMFTomBooker wrote:

    So the Fed steps in and lowers interest rates to .25%, pays the banks .25% to do nothing with outsized reserves, buys a $trillion+ in non-marked MBS garbage from the Banks, and QEs into being the largest holder of US debt in the world.

    Every single retired person in the US is given the choice of being net negative on fixed income investments, or buying riskier investments.

    But helping the Demand side with a net de-leveraging has unforeseen collateral damage which you CAN see in your crystal ball.

    I think the collateral damage from monetary and fiscal policy train has left the station.

    It's about evening out the lopsided "Recovery".

    Somebody will take a hit? And it's part of the same bunch who should have taken the full impact of the collapse of the Shadow Banking System?

    Boo hoo.

    And you are absolutely correct, write downs for the Banks and individuals would only be postponed.

    Why is the same logic to liquify the Supply side "until the markets stabilize" (Paulson and Bernanke's words), bad logic on the Demand side?

    When did TMF's editorial bent join the early retirement and $2MM job on Wall Street mentality?

    The prejudicial give away is the arrogance of the assumption that the found cash will go to discretionary items and not to other household de-leveraging or savings or investment which can hedge against futher damage of underwater mortgages.

    The last thing we want is the bounty of the artifice to reach the people on their way to eviction from the Middle class.

    Yep, those stupid ignorant people.

    What's life like in your gated community?

  • Report this Comment On January 10, 2012, at 10:00 PM, CMFTomBooker wrote:

    My apologies. Even for the opinionated blowhard I am, that was over the line.


  • Report this Comment On January 13, 2012, at 11:30 PM, wksch wrote:

    I like REITS. I am long IVR.

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