Jack M. Guttentag The Mortgage Professor

Last week I criticized the government's new two-part program, Making Home Affordable, for being too narrow and limited in scope. This article describes the refinance part of the program, which applies only to mortgages owned or guaranteed by Fannie Mae or Freddie Mac.

Purpose: The objective of the refinance program is to allow borrowers to refinance who would otherwise find it impossible or excessively costly because of declines in the value of their properties. Under the program, loan balances can range up to 105 percent of current property value, but in all other respects, borrowers must meet conventional underwriting requirements: their existing payments must be current, they cannot have more than one 30-day late payment in the previous 12 months, and their income must be sufficient to cover the new payments.

Pricing: Interest rates under the program are "market rates," but what that really means is hard to say. It is not clear, for example, whether the agencies will charge more for a 90 percent loan that does not have mortgage insurance than for one that does. Whatever it means, we can be sure that prices will fluctuate from day to day, and that the prices loan originators quote to borrowers will include varying markups and fees on top of the prices at which they sell to the agencies. Markups will be particularly high on loans held by Freddie Mac, which will only accept loans refinanced by the lender now servicing them.

Mortgage Insurance: An unusual feature of the program is that any mortgage insurance on the existing loan will be carried forward to the new loan. (Ordinarily, mortgage insurance is terminated when a loan is paid off and, if required, a fresh policy is issued on the new mortgage). The mortgage insurers have to agree to this arrangement, but since it is clearly in their interest, that should not be a problem.

This is a sensible idea because it prevents a sudden drop in insurance premiums to the beleaguered mortgage insurers, and it also provides a way to comply with the rule that any loan acquired by Fannie or Freddie that exceeds 80 percent of property value carry mortgage insurance or its equivalent.

Rationale of the 105 percent Loan Cap: Capping the loan balance at 105 percent of value presumably is based on a judgment that borrowers with adequate income and a good payment record are not going to default just because they owe 5 percent more than their house is worth. That makes sense. What doesn't make sense is that borrowers with more than 5 percent negative equity are not eligible for the refinance program at all, and can't get their problem fixed by a loan modification under the second part of MHA.

Eligibility: In its documentation, the Treasury states that eligible borrowers must occupy their homes, a provision I criticized last week. Interestingly, Fannie Mae's description of the program indicates that second homes and investor-owned properties are eligible, contradicting the Treasury. Let's hope Fannie prevails.

Eligible structures can have up to four dwelling units so long as the borrower lives in one of them.

The home can have a second mortgage, the balance of which is not counted in the 105 percent cap, but the second mortgage lender has to agree to remain in a second lien position. Some second mortgage lenders charge a fee for stepping aside, so this could pose a problem in some cases.

Borrowers are not allowed to withdraw cash from the transaction, even to pay off other debts. However, they are allowed to include settlement costs in the new loan balance.

By far the most questionable eligibility rule is the one that restricts the program to borrowers whose mortgages are held by the agencies or are in a security guaranteed by them. Borrowers had no control over which investor ended up with their loan, yet this crapshoot now separates those who are and are not eligible for the program. Is there a good reason for excluding the other half of the market?

Questionable Rationale For Limiting the Program: As noted above, the agencies must obtain mortgage insurance on any loan they purchase that exceeds 80 percent of property value. Their regulator, the Federal Housing Finance Agency (FHFA), has stated that the agencies will be in compliance with this rule when they refinance loans they already own or guarantee because they are already responsible for any default losses on these loans and the refinance does not increase that risk. This rationale would not apply to loans owned by other investors.

However, the agency would also be in compliance with the 80 percent rule if it purchased loans held by other investors that now carry mortgage insurance that the insurer has agreed to transfer to the refinanced loan. This is true as well of loans that originally met the 80 percent rule and still do. In a financial crisis, the net should be as wide as possible.