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posted: 11/12/2011 12:01 AM

Mortgage Professor: A plan to jump-start housing

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Editor's note: This is the final column in a three-part series appearing in HomesSaturday detailing how to jump-start the housing market.

Previous articles in this series argued that absent a liberalization of Fannie/Freddie lending terms, a second round of home-price declines is very likely. Renewed price declines will have a devastating effect on homeowners and the economy, and would also increase Fannie/Freddie losses on both old and new loans. This makes the liberalization of lending terms a requirement of responsible conservatorship.

The changes needed include a rollback of risk-based price adjustments to where they were before the financial crisis, and relaxation of misguided underwriting rules. Previous articles focused on the need to modify rigid affordability rules, eliminate income documentation requirements for sterling borrowers, and eliminate the requirement for property appraisals on purchase transactions. This article identifies a few more.

Liberalize lending terms and remove restrictions on loans to investors

Investors buy houses to resell or to rent rather than to occupy. During the go-go years, investors bought houses to resell at a profit, and in the current depressed market, they are buying houses either to sell or to rent until the market improves. Laurie Goodman has shown how important investors are to restoring a demand/supply balance in the current market. The problem is that there are fewer investor loans now when we need them, than there were before the crisis when we didn't need them.

The major barrier to additional home purchases by investors is the onerous rules imposed on investor loans by Fannie/Freddie. In September 2006, Fannie Mae charged 1.5 to 2.5 points extra if the borrower was an investor rather than an occupant, and investor loans could be up to 90 percent of property value. Today, the price increment is 1.75 to 3.75 points, and the maximum loan is 85 percent of property value.

Fannie/Freddie also limit the number of loans that any one investor can have to four, with up to 10 allowed under more restrictive lending terms. This restriction has the effect of limiting the home investor market to small players.

The higher prices, lower maximum loan-to-value ratios, and limits on the number of loans an investor can have are all counterproductive in the current environment. Investor activity would be stimulated if 90 percent loans were available at a 1 point price increment and limits on loan numbers were eliminated. When home prices start rising by more than 3 percent a year, the old rules could be reimposed.

Eliminate LTV and appraisal requirements on HARP loans

The Home Affordable Refinance Program was designed to make refinance possible for underwater borrowers who are current on their payments and whose loans are owned by Fannie or Freddie. A major problem with the program is a maximum loan-to-value ratio, or LTV, of 125 percent, which cuts out a sizable segment of the potential market for no good reason.

I can see why the agencies might have limited the program to borrowers with LTVs above 125 percent. The net loss to the agencies from refinancing is lower for high-LTV loans than for lower-LTV loans because high-LTV loans are more likely to default and lower interest rates will prevent some of these defaults.

The loss to the agencies from refinancing underwater mortgages is the interest loss on loans that would have remained in good standing had the refinance not occurred. This loss is not related to the LTV. The benefit to the agencies is the loss avoided on loans that would have defaulted but don't because of the rate reduction. This benefit is larger for higher-LTV loans, which are more likely to default.

By scrapping the LTV maximum in the HARP program, the agencies would also eliminate the need for appraisals, which would simplify the program and expedite the implementation.

Concluding comment

There are many more changes in Fannie/Freddie rules that would help to generate increased housing demand, but my internal editor says that more examples are not needed. The overriding need is recognition by the agencies and its conservator that assets are not conserved by acting as if Fannie and Freddie are small lenders with no power to affect the market. They are a major part of the market, and their assets are best conserved by policies that convert the currently anemic market into a healthy one. Once that principle is accepted, I will be happy to flesh out the list, and so will many others.

• Contact Jack Guttentag via his website at