In the past, discussions about how to help distressed homeowners have focused on making banks take principal reductions on mortgages and positioned homeowner relief as a zero-sum game between the government, banks, and homeowners. However, the decline in mortgage interest rates makes possible a scenario that, in theory, can benefit all parties. In brief, here’s how it would work:
1) GSEs issue 30 year callable bonds at 2.5% - 3% effective yield (see here for current secondary market prices showing that is a competitive yield).
2) GSEs uses the capital raised to offer special refinancing offer to distressed homeowner and bank that would reduce the homeowner’s monthly payment and provide non-dilutive capital to the bank:
a. Up to 33% of the current assessed value of the property can be refinanced with a 30-year fixed rate mortgage at 4% interest provided the homeowner and current note-holder agree to the following conditions:
i. All penalty or accumulating unpaid interest is forgiven by the current note-holder.
ii. The current note-holder pays all administration, closing, and servicing costs on the refinancing note.
iii. The full amount of the new loan is used to pre-pay principal on the existing note, providing a partial liquidity event to the current note-holder.
iv. The existing note-holder enters into a subordination agreement that positions the principal and interest from the GSE refinancing event as first-lien.
3) GSEs attempts to sell their new notes to private investors.
What happens to each party:
1) The GSE profits from the rate spread between the bonds they initially issued and the notes they purchase with the proceeds. Given the first-lien position of the new notes and the fact that they are secured by a property currently worth at least 3x the value of the note, the GSE is almost assured a nominal profit. Only if property values drop more than 66% from their current levels would the GSE notes’ principal be in jeopardy.
2) The banks holding distressed notes would be able to realize a partial liquidity event without necessarily triggering a write-down of any of the remaining balance. The big banks need additional capital and this would enable them to raise non-dilutive capital on fairly attractive terms.
3) The homeowners would be able to stay in their houses and significantly reduce their monthly payments. If they are currently paying a 5.5% interest rate on their entire 30-year mortgage, the new terms would allow them to pay 4% on 33% of the loan and 5.5% on the remaining 66%. This reduces their annual mortgage interest by 0.5% of the total outstanding balance each year. In other words, if they owe $300,000 on their house, their mortgage interest will be reduced by $1,500 that year and their monthly payment over the life of the loan will be reduced from ~$1703.37 to ~$1610.46 or >5% every month.