Alarm Bells Ring Over Refinance Mortgage Boom: Why Refis Are So Risky


Mortgage lobby throws hissy-fit over Fannie Mae’s & Freddie Mac’s new 0.5% “Adverse Market Refinance Fee,” which was a “result of risk management and loss forecasting precipitated by COVID-19 related economic and market uncertainty.”

The mortgage industry is in uproar over the surprise announcement by Fannie Mae (OTC:FDDXD) and Freddie Mac (OTCQB:FMCC) (the GSEs) Wednesday night that they would charge a 0.5% “adverse market refinance fee” on refinance mortgages that they buy – “a result of risk management and loss forecasting precipitated by COVID-19 related economic and market uncertainty,” said Freddie Mac’s statement sent to lenders.

The fee is designed to reduce potential losses for taxpayers that back the GSEs, as these GSEs now see the mortgage market, and particularly refis, heading for trouble. Refis carry a lot higher risk than purchase mortgages. More on that in a moment.

This fee will be effective September 1. To refinance a $500,000 balance, the fee would amount to $2,500. It’s not the end of the world. Mortgage lenders pay this fee to the GSEs, but they’ll try to pass at least part of it on to the borrower. The fee will be applied to cash out and non-cash out refi mortgages.

Who profited from the refi boom and who carries the risk?

On Thursday, 20 lobbying groups representing the mortgage and real-estate industry – including the Mortgage Bankers Association (MBA), the National Association of Realtors (NAR), and the National Association of Home Builders (NAHB) – responded with a letter, opposing the fee, because it would threaten “the emerging, but unsteady improvements to the national economy,” and raise refi costs, which would be “particularly harmful for our nation’s low- and moderate-income homeowners,” and would be, therefore “contradicting and undermining Fed policy.”

Turns out, these 20 lobbying groups don’t represent anyone but their clients in the mortgage and real estate industry – mortgage bankers, mortgage brokers, real estate brokers, home builders, and others. And these clients have all hugely profited from the refi boom that the record low mortgage rates, which have dropped nearly 1 percentage point since January, have brought about.

And none of the clients of these lobbying groups carry the risks of these refi mortgages. The GSEs – Fannie Mae and Freddie Mac – carry those risks, and ultimately the taxpayer.

This then triggered two counter-punches from the American Enterprise Institute’s Housing Center, sent out by email on Thursday and Friday.

“The Housing Lobby has described the GSEs’ imposition of a new ½-point market adjustment fee to offset risk on refinance loans as: “outrageous,” “a cash grab,” and “based on jealousy, greed, and disdain.” Nothing could be further from reality,” the AEI’s first statement said.

The GSEs are already strung out on refi mortgages, according to the AEI:

  • “The GSEs’ share of the entire cash-out refinance market is now at 90%, up from about 75% at the beginning of 2020.” That’s how exposed they are.
  • “The GSEs’ share of the entire rate and term refinance market is now at 80%, up from about 63% at the beginning of 2020.”
  • “Recently the combined volume of cash-out and rate and term refinance rate locks has been more than double the level a year earlier.” That’s how much the refi market has boomed under the record low interest rates.

The refi market share of the FHA, the VA, and private-sector lenders are down because they “have appropriately tightened credit standards,” the AEI said. The GSEs too have tightened standards, but “not been enough to slow their massive share and volume increases.”

“Mortgage lending history teaches us that lending into a vacuum is dangerous, and nothing indicates that more than a massive increase in share compared to one’s competitors,” the AEI said.

“The new ½-point market adjustment fee is not only appropriate, but it would have been a dereliction of regulatory oversight not to have taken action,” the AEI said.

Risks for refis are high because home “value” may be fantasy.

A cash-out refinance mortgage with 30-year fixed rate, fully documented, with a 65% loan-to-value ratio – meaning the loan amount equals 65% of the home’s “value,” seemingly leaving a lot of “equity,” thus seemingly very low risk – has the same default proclivity under stress as similar purchase mortgages with a 91-95% loan-to-value ratio.

In other words, seemingly low-risk refis are as risky as much higher-risk purchase mortgages; and compared to purchase mortgages with equivalent metrics, refis are much riskier.

“And the GSEs currently guarantee cash-out loans up to 80% loan-to-value,” the AEI said.

The major reason why refis are so much riskier than purchase mortgages is the simple fact that there is no arm’s length transaction and no arm’s length purchase price that determines the value of the home.

It boils down to this question, the AEI said: “what do you need the value to be?”

No appraisal, no problem.

This valuation risk has been further heightened by increased use of “automated appraisal waivers” that the GSEs use to decide when no appraisal is needed. So now, there is no arm’s length transaction and not even an appraisal.

“Given that this tool is embedded in the GSEs’ automated underwriting systems (AUSs), and a loan may be submitted multiple times, this system is subject to gaming. We saw this happen with waivers of income documentation back in the ’00 years,” the AEI said.

“Automated systems make it much faster to distribute system-based underwriting rules and home price information to the marketplace,” the AEI said. “Given the GSEs’ 60% market share, it would be hard to design a system that was better at fueling refinance demand and risk.”

“Yet, like the AUSs of the ’00s, the GSEs’ large scale use of automated appraisal waivers today has not been tested in a down cycle,” the AEI said. “In the ’00s, we ultimately found out they were so wrong, that virtually all local markets were subjected to severe home price corrections the likes that hadn’t been seen since the Great Depression.”

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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