HARPooned: Fed Mortgage Mods Let Owners Spear Self In Foot

Headlines showed up recently praising a revamped Mortgage Modification program proposal coming out of Washington.  The official acronym is HARP.  Here are some highlights courtesy of Housingwire:

The plan...allows borrowers in privately funded loans to refinance into a lower rate Federal Housing Administration mortgage. The program would be expected to cost between $5 billion and $10 billion through a tax charged on the banks.

A separate option under the program would apply to borrowers in Fannie Mae and Freddie Mac loans as well. Anyone who refinances could reduce the term of their mortgage to less than 20 years. If the borrower commits to keeping the monthly payment where it is, the GSEs or the FHA would cover the closing costs estimated at roughly $3,000 per refinance.

This is government intervention in the market at its worst.  To understand how bad this policy is, you have to follow the money chain.  Currently, many banks own loans issues to homeowners during the housing bubble.  Many of those loans went bad over the past few years and those banks are now licking their wounds trying to rebuild capital and stay afloat.  For the good loans that are left, the bank receives a monthly payment that includes interest and a portion of principal.  This is income to the bank.

What the HARP program proposes is to refinance the bank's good loans (i.e. eliminate its income source) and lend the homeowner money from FHA (a loan insured by my tax dollars and yours). At prevailing rates which are far lower than rates on loan issues several years ago.

So what kind of crazy consequences could come from this kind of policy?  There are several.

First, the program has the potential to handicap the banks even further.  By holding good loans that have interest rates above prevailing interest rates today, the banks can make use that money to repair their balance sheets and return to health.  If those loans are refinanced, it means that the bank looses that income and must reissue those funds in new loans at todoay's lower rates.  This reduces their income stream and postpones their return to health.

Even more sinister however is the effect that future inflation could have on these banks.  If the bank reissues its entire portfolio at today's record low rates, when rates increase, it means that the banks will be loosing money again hand over fist as borrowers have no incentive to refinance at punitively higher rates.  Inflation could drag banks back into insolvency at interest payments on savings and deposits exceed interest income on loans.   

Think about FHA and all these government owned loans.  What does it mean to the taxpayers if their money is sitting in super low interest loans as inflation pushes interest rates up?  These loans become a loss on the public balance sheet.

Add interest rate risk to the fact that the Feds want to tax banks to pay for a forced divestiture of their assets and you have a recipe for gross unintended consequences.  It's the equivalent of thugs ransacking your house, taking your valuables, and then sending you a bill for their efforts.

It might be tempting to say, "Hey, those slimy banks deserve it!".  Well, not all banks are slimy.  Unfortunately, this policy proposal will affect the good as well as the bad. How much better off will the public be when their good banks whither? The public should not be surprised when their local bank gasps for air after having been HARPooned by the Feds.