Ask An Economist

Matt has asked me to comment on this:

The Obama administration's plan to stave off foreclosures could fall flat in California, where nearly one-third of mortgage holders are underwater on their loans -- many of them by amounts that would disqualify them for government-sponsored refinancing.

The problem is likely to be especially acute in areas like the Inland Empire, where homes have lost more than 40% of their value in the last year and nearly half the homeowners owe more on their loans than the properties are worth.

Since Fannie Mae and Freddie is figured prominently in the Obama plan, I need to provide some color on this. F&F own about 50% of all mortgages in the US, and any modification means an actual loss of money.

Let's use an example. Suppose Fannie buys 100 mortgages (each of whom at 6% fixed rate). The way Fannie makes money is to sell a MBS-pass-through that has a rate of 5.5% to, say, Bank of China. Fannie makes a living off of that 0.5% interest margin.

Now here is the twist. This 0.5% margin works as a form of "insurance" for Bank of China (the actual mechanism is g-fee, but let's ignore the gory financial detail for this exposition). That is to say, even if all 100 mortgages go bad, Fannie is committed to pay that 5.5% interest to bank of China.

So what does that mean? It means that suppose Fannie Mae modifies all 100 loans to 5%, they are still on the hook to pay that 5.5 interest payment to Bank of China. It means that Fannie Mae is deliberately losing money.

This doesn't mean we should not do it- doing nothing will be far worse. But it does mean that there is not enough money to modify everyone's mortgage. Fannie got an additional $100 billion from the Fed, and they will be burned through as a result of this modification plan. It has to make a decision as to who can be modified and cannot because the Fed's budget is big, but not infinite.

And unfortunately this means that someone will be left out, and places that are too far underwater: parts of Phoenix, LA, Miami, are implicitly left out of this triage process. Or rather, they have been triaged and it has been deemed that they are too expensive to save. It is a cruel reality, but it is the reality.