Monday, March 26, 2007

Bail out?

Interesting story from Bloomberg news on Friday which past without too much notice. The bottom line is the Ohio Housing Finance Agency, which is a state agency, is offering low to middle income home owners the opportunity to refinance their ARM mortgage into a fixed rate mortgage at 6.75%. That's well above the Freddie Mac survey rate of 6.14%, so you can infer that this program is aimed at sub-prime borrowers.

Now, dear reader, I'm not a true expert on too many things, but I'll bet there are few bloggers out there who understand municipal housing bonds as well as I do. So here is what you need to know about this deal, and what it really means for the sub-prime market in general.

Many, if not most, states have some sort of housing agency. In terms of their single family programs, most operate a bit like Fannie Mae or Freddie Mac, offering to buy qualifying mortgages from originators. They may be involved with multi-family housing projects also, which is a whole other topic.

Unlike the GSE's, the state housing agency is generally pursuing some social goal as opposed to a profit. Most commonly in order for the borrower to qualify for the state agency program they must be below some income figure, be buying a house in a certain area (typically an area the state wants to revitalize), be a first-time buyer, etc. The agency may offer a program with a below market interest rate, or else offer a higher rate but favorable down payment assistance, or some such.

Despite the agency's altruistic intentions, these programs are usually wildly profitable. How you ask? Because as a state agency, they can issue tax-exempt debt. So let's say they have a program where borrowers with low incomes can get a 30-year mortgage at 6% with a mere 2% down payment. Risky loan right? Heck yeah. But the agency can issue tax-exempt debt to fund the program at say 4.5%. The agency is collecting 150bps of yield above their funding cost. You can suffer a whole lot of defaults when you are earning that kind of spread.

In fact, all the state housing agencies I've ever invested in aren't even taking that risk. They actually either buy private insurance, package the loans and sell them to someone like Ginnie Mae, or run their programs in conjunction with a FHA, VA or Department of Agriculture program. All of this results in the agency selling off the actual default risk to someone else, most often the U.S. Treasury. Notice that if they are selling the risk to the Feds, the loan usually has to pass FHA lending standards, which don't allow a lot of the creative lending options that are getting so much negative press today.

Note that in almost all cases, state housing agencies are stand alone entities. They have no backing from the state, nor do they receive any appropriated money from the state. They are able to subsidize risky borrowers entirely because of their massive funding advantage.

Enter the IRS. The tax code says that there is a limit to how much tax-exempt debt can be issued for the benefit of private individuals. That's exactly what we have here: these private individual borrowers are benefiting from either lower rates or relaxed lending standards. For this reason, often times, instead of being truly tax-exempt, housing bonds are sold as "AMT." That means that interest on the bond is tax exempt to any individual holder so long as the holder does not fall into Federal AMT tax status. In that case, the interest is fully taxable. Obviously the rate on a bond like that is higher than plain vanilla tax-exempt bonds, but only marginally so.

Anyway, it is illegal for tax-exempt bonds to be sold for purposes of refinancing a mortgage. In other words, almost all housing agency programs are for home purchases only. Not for refinancings. Ohio will therefore have to sell fully taxable bonds for this program. They will still have a positive spread between their funding rate and the mortgage rate. I do a lot in the taxable municipal housing market, so I'd say that their funding level will be somewhere in the 10-year +100 area, so something like 5.60%. Since this program is going to have a 6.75% lending rate, its no problem. Still, after the agency either pays for mortgage insurance or sells the portfolio to Ginnie Mae, their profit will be relatively low.

But the impact on foreclosures in Ohio could be significant. One of the ultra-bearish scenarios for housing is that tighter credit standards at banks prevent ARM borrowers from refinancing into fixed rates. The borrower can't afford the reset, and the house going into foreclosure. If state housing agencies can step in an offer a middle ground, it could help tremendously.

Is it a bail out? Maybe, but this is the kind of program housing agencies have been offering to home buyers for a long time. The only thing that's going to be new here is the opportunity to refinance with a state housing agency program. Plus, tax payer money is not at risk here, at least not on the state level. Some Federal tax payer money is at risk at Ginnie Mae perhaps, but the amount is going to be pretty small in the scheme of the Federal budget.

I had lunch with the director of the Maryland Department of Housing and Community Development about 2 years ago. He complained about the fact that these new fangled mortgage products were taking away all their business. Traditionally, the first time home buyer with very little to put down and light credit history was a client of state housing agencies. Now the same borrower was opting for a interest-only or option ARM from someone like New Century. Whereas the housing agency might have only approved an ARM where the borrower could afford a maximum reset, and required at least 3% down, other lenders were offering zero down and approved based on the teaser rate.

So ironically, the sub-prime bust may be bringing better times to the state housing agencies. And I really think if more states follow Ohio's lead, it could have a very positive impact on foreclosures.


Marshall said...

Many of the outstanding subprimes used neg am and low teaser rates. Most will not qualify at 6.75%. Many have pre-payment penalties and what about loan debits greater than appraised values. Not sure these plans will do much.

BondBaron said...

I completely agree with your points in this post and while I was not aware of the impact of state agencies I have been following the FHA's proposal to have their lending standards revised to make them more 'competitive' with non-traditional mortgage products.

What is somewhat shocking in hindsight is the huge drop in FHA issuance from 2000 to 2006. In California (the largest decrease quoted) issuance fell from 109,074 loans to 2,599. The link to the Assistant Secretary for Housing's testimony in support of changing standards is below.

My view:
Is housing in trouble? Probably not because the government will step in at some point to support housing (by raising maximum total loan values). Are sub prime originators? The jury's still out because FHA issuance is a public-private partnership whereby the same mortgage broker which sold the option ARM will be able to roll the homeowner into an FHA insured mortgage and collect fees again but when? and will it be in time?

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Vivek Vish said...
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Irwin said...

I completely agree with your points in this post and while I was not aware of the impact of state agencies I have been following the FHA's proposal to have their lending standards revised to make them more competitive with non-traditional mortgage products.