No Fee Refinancing – Great News!
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
A recent article by The Motley Fool's own Dan Caplinger, “Great News for Mortgage Seekers” caught my eye as I have a mortgage and would love to hear some good news. In this piece, Dan outlined a new proposal from the Consumer Financial Protection Bureau that could eliminate fees for refinancing. So called fee-free refinancing would be great news for homeowners. There is just one big problem the C.F.P. apparently doesn't realize, there is no way it works. I worked for a large bank for over 10 years and let me tell you, the proposal as I understand it has little to no chance of really being the great deal that it seems to be on the surface.
How Would This Fee-Free Refinancing Work?
The crux of the proposal is mortgage lenders would be required to offer a fee-free option to homeowners to refinance. One of the barriers to refinancing is the “thousands of dollars” in appraisals, legal fees, and title insurance fees that must be paid up front. Once a homeowner pays several thousand to refinance their loan, they aren't going to do it again unless rates drop significantly. With 30 year mortgage rates still near record lows, a large drop in rates from here is near impossible. In theory, “removing the barrier to refinancing would lead to a huge increase in refinancing activity”. Banks could ultimately see this as a good deal, as they would still be able to sell the loans as securities and make transaction-related income. On the surface this sounds great, lower rates for homeowners, simpler loans, banks make money, everyone is happy right? Yeah, not so much.
Problem #1 – Fees Aren't The Problem, Valuations Are:
Probably the single biggest obstacle to refinancing today is homeowners who are underwater on their mortgage. According to a report by Zillow, 31.4% of U.S. homeowners are underwater on their mortgages. This means we have just effectively eliminated all of those homeowners from refinancing. Technically it is true that homeowners might be able to refinance if their first mortgage isn't underwater, and they have a second mortgage that causes the problem. However, most mortgage companies would add points to this homeowner’s interest rate because of this risk. This means though a standard 30 year mortgage might be at 3.6%, this underwater homeowner might have 0.25%, 0.50%, or more added to their base rate before you even get to the fee discussion. For homeowners who have just their primary mortgage and the home is worth less than the balance, there isn't much banks can do.
Problem #2 – What About Past Due Loans?
Another issue with this proposal is it assumes that there are a lot of homeowners who haven't refinanced, and who also are current on their loans. Clearly this just isn't the case. In Bank of America's (NYSE: BAC) last earnings report, they said that over 1 million of their legacy first mortgage loans were at least 60 days past due. Keep in mind this was just in the bank's legacy assets, in their total loan portfolio they saw an increase of about $2 billion in non-performing assets. If a homeowner is past due, usually a modification is what is needed and a traditional refinance is out of the question. The problem is, though modification success has improved, it isn't a cure all. According to a story in The Boston Globe, “about 70% of the nearly 448,000 U.S. homeowners who received mortgage help from lenders in the first nine months of 2011 are still up to date on their mortgages.” As an example, a couple who had an adjustable rate through Wells Fargo (NYSE: WFC), had their rate cut from 8.5% to 3%, which saved $1,500 off of a $3,500 monthly mortgage payment. The issue for Wells Fargo is, now this loan becomes an asset that Wells can't readily sell to other investors. In addition, while this one example is good news, Wells still has about 3.24% of consumer non-performing assets. With over $400 billion in consumer loans, an over 3% non-performer rate is a large number indeed.
Problem #3 – Who Would Want To Buy These Loans?
Probably the biggest sticking point to the idea of fee-free refinancing is, who would want to buy these loans? In order for this idea to work, banks would have to be able to earn transaction-related income when they sell these so called “fee free” loans. If this practice were to become wide-spread, who wants to buy this stuff? A REIT like Annaly Capital (NYSE: NLY) buys a lot of fixed rate securities. However, the company lists as one of its main risk factors, pre-payment of loans. If Annaly buys a 30-year security with a coupon of say 4%, they make certain assumptions. The company knows about how long it should be able to earn interest on this security, and can borrow funds at cheap short-term rates to make money on the interest spread. Since the spread and timeframe are both relatively predictable, the company can leverage up its balance sheet to earn superior returns for shareholders. What happens if fee-free mortgages become the norm? The short version is Annaly and companies like it will have to change their assumptions completely. What is the end result? Believe it or not, the result would be higher mortgage rates. According to Investopedia, “investors try to maximize returns; they frequently run relative value analyses between mortgage-backed securities and other fixed income investments such as corporate bonds.” Logically if mortgage-backed securities have a higher pre-payment rate, than other fixed income investments become more predictable, and thus more attractive even at slightly lower rates.
In the end its real simple, a fee-free mortgage option will result in a higher rate for the borrower at the time of refinancing. If a mortgage company or bank can't make anything on fees up-front, these lost fees have to be subsidized by a higher rate. If fee-free mortgages allow borrowers to refinance more frequently, investors will require higher rates because of the greater pre-payment risk. Long story short, what consumers would receive is, higher rates up-front and higher start rates because of the less attractive nature of mortgage-backed securities. In order for borrowers to get in on this, they also have to not be underwater or late on their payments. On the surface the proposal seems like good news, but if this makes its way to reality, the higher rates required by banks and REITs won't be any help to consumers.
MHenage owns shares of Annaly Capital Management. The Motley Fool owns shares of Bank of America, Annaly Capital Management, and Wells Fargo & Company and has the following options: short OCT 2012 $33.00 puts on Wells Fargo & Company and short OCT 2012 $36.00 calls on Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. 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 Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.