Do you understand the President’s new housing plan? It’s supposed to help prevent foreclosures.  Even after the plan “details” were released on March 4th, there are still lots of unanswered questions. And for now there have been no official releases that answer these questions.  The few details that have been released should create some concern. Who thinks these things up anyway?

To understand what’s going on here, let’s lay the groundwork. The bulk of loans in the United States are underwritten (the process of deciding whether a borrower is financially qualified for a loan) according to Fannie Mae and Freddie Mac udnerwriting guidelines.  One of the factors used in determining whether applicants are creditworthy is the evaluation of their debt in relation to income. Simply stated, borrowers who have high debt in relation to their income are less creditworthy than those with lower debts or higher income.

In evaluating this relationship lenders rely on two variations of debt ratios.  One is referred to as the “top-end” ratio. It’s the ratio that an applicant’s housing expense bears to his or her gross monthly income. The “housing expense” includes all mortgage payments secured by the property together with the monthly amount of taxes and hazard insurance associated with the property. The definition of housing expense has recently been amended to also include association dues owed in connection with ownership of the property.  The housing expense is often referred to under the acronym “PITIA” (representing “principal”, “interest”, “taxes”, “insurance” and “association dues”).

The other debt ratio used by lenders in evaluating creditworthiness is the total debt-to-income ratio (or “DTI” ratio), often referred to by lenders as the “bottom-end” ratio. The “debt” utilized in calculating this ratio includes the housing expense (PITIA) plus all monthly payments made by the applicant on installment and revolving (credit card) debt. This may be a slight over-simplification of the definitions, but it will do for our purposes.

Prior to the preceding decade mortgage lenders used two sets of debt ratios to determine creditworthiness for all applicants. For transactions with loan-to-value ratios above 80% the applicant’s top-end ratio could not exceed 28% and the bottom-end ratio could not exceed 36%.  For transactions involving an LTV ratio of 80% or less the ratios had to fall between 33% and 38% respectively. I’ve never been provided with any good explanation of why these particular limits were used. As best I can ascertain they were pulled out of thin air.  They just seemed to make sense, so banks used them. Hardly scientific.

Well, somewhere around 20 years ago, the big-wigs at Fannie Mae and Freddie Mac decided to do something interesting. Why not take a look at the statistics they had in their possession about default on loans and try to correlate default with applicant characteristics such as credit history and debt ratios?  What they discovered was that utilizing only two sets of debt-to-income ratio limits for all borrowers was a pretty unreliable way of assessing whether a borrower was creditworthy.  Using the traditional 28/36 ratios was a little bit like throwing darts at a dart board wearing a blindfold.

The new empirical models that were developed evaluated dozens of factors relating to an applicant to determine whether they were creditworthy. With two decades of data at their disposal lenders have been able to fine tune the process.  The risk models used in the mortgage industry today rely most heavily on the applicant’s credit scores (based on empirical data gathered by a couple of guys named Mr. Fair and Mr. Isaac), the aforementioned debt-to-income ratios, and the ratio that the proposed loan amount bears to the value of the property securing the loan (the “loan-to-value” ratio).

Armed with this information regarding debt-to-income ratios you have only half the knowledge you need to evaulate the President’s plan. To fully understand the ramifications of the plan you’ll also need to know a little bit about the various players involved in the mortgage industry.

When a borrower obtains a mortgage loan it’s delivered at the retail level primarily by mortgage brokers, mortgage bankers, or traditional banks. These entities that accept loan applications and process them are collectively referred to as “originators”.

The originators then transfer these loans to other entities in the “secondary market”.  The vast majority of these mortgage loans are then pooled into groups with similar interest rates (called coupons). These pooled loans are then used to collaterize bonds that are sold to investors.  These bonds typically have yields higher than treasury notes and bonds. There’s a pretty good chance that if you have a 401K or retirement plan, that some of the assets in the plan are these types of bonds.  Some of these bonds are owned by individuals like you and me. The owners or holders of the bonds, acting through a trustee, will contract with “servicers” who are charged with the responsibility for accepting payments from the mortgagor, assuring that taxes and insurance are maintained on the property securing the mortgage loan, and other administrative functions. In theory, if not in practice, the servicers are fiducaries charged with the duty of protecting the interests of the owners of the bonds.

One of the duties of the servicer is to work with borrowers who are in default and to attempt to mitigate losses to the bond owners in the event of borrower default. A small percentage of these mortgage-backed bonds are owned by the servicers themselves, but the bulk of these bonds are actually owned by Fannie Mae, Freddie Mac and private investors who hold these bonds in their security portfolios.

Having established the underwriting rules and players in the game, let’s now evaluate the plan.

The “modification” section of the plan proposes to permit a homeowner whose top-end (housing) ratios exceeds 31% to obtain an interest rate reduction to the extent necessary to bring the top-end ratio to 31% or lower. In other words, the plan returns to the dark ages of underwriting to use a single debt ratio to determine whether a homeowner is at risk of default on their mortgage loan.  It ignores 25 years of impirical research. And in doing so, it will cost American taxpayers billions, if not trillions of dollars, to subsidize the mortgage loans of their neighbors who are not remotely at risk of default.

Consider the following example: John Oglethorpe owns a home worth about $500,000. He has an outstanding balance of about $380,000 on his existing mortgage, that has an interest rate of 6.25% and a payment (including tax and insurance escrows) of $3,296.20.  His gross monthly income is $7,800.  Thus, his top-end ratio is 42.26%. After paying his monthly housing expense this guy has about $3,700 each month left over to pay for transportation, food, insurance and other living expenses.  This guy could own a Mercedes Benz and Porsce and still have plenty of greenbacks left over to buy a few bologna sandwiches.  Frankly, the guy isn’t even remotely at risk of defaulting on his mortgage.

Yet under the plan Mr. Oglethorpe’s mortgage loan servicer is given an incentive to reduce Oglethorpe’s rate to 4.875% so that the monthly payment is reduced to $2,950.16 (thereby reducing the top-end ratio to 38%).   But the goverment, having determined in its immenent wisdom that a 38% top-end ratios is still too high, wants to lower Mr. Oglethorpe’s rate and payment even more, so it persuades the servicer to reduce the rate by an additional 2.375 percentage points to 2.5% and the payment to $2,413.81 (thereby reducing the top-end ratio to the targeted 31%). The government will subsidize this second rate reduction by paying half of the amount by which the payment is reduced for up to 5 years.

Let’s do the math. With the second reduction (from a 38% to 31% top-end ratio) the borrower’s payment was reduced by $536.35. So the government foots the bill for 50% of this amount for 60 months for a total subsidy of $16,090.05. As if the gratuitous reduction in rate and payment were not incentive enough, the government is going to pay the borrower $1,000 each year for 5 years for accepting this new lower rate and making his payment on time for that 5 year period.  That’s right we’re going to pay the borrower $5,000 for accepting a reduction in rate to 2.5% for five-years. Mr. Oglethorpe’s no dummy.  He immediately says, “Where do it sign?”

Of course, the borrower isn’t the only one receiving a windfall in this little modification effort. The servicer that arranges the modification prior to default will be paid $1,500 up front plus $3,000 more dollars during the next three years.

How much money will the borrower (who we already concluded was never at risk) will save during this 5 year period. He’ll reduce his monthly nut by $882.39 each month for 60 months for a cumulative monthly savings of $52,943.40. And if that weren’t enough, we’ll pay him an additional $5,000 for accepting the lower rate and paying his payment for the next 5 years.  Total benefit to the undeserving borrower? $57,943.40.

Who pays for these benefits? Well, it’s probably not the servicer since the bulk of the mortgage loans that will be modified under the plan are either owned by Fannie Mae, Freddie Mac, or private investors (such as your pension plan or 401K plan).  We’ll assume for the sake of argument that this particular loan is packaged into a pool of loans securing a mortgage backed bond that’s owned by your 401K plan.

Of the total $63,943.40 that’s benefits the borrower, loan servicer and note holder in this modification fiasco, $27,090.05 is paid by millions of taxpayers, their children and grandchildren for decades to come. The remainder of the windfall to the borrower ($26,853.35) is paid by your 401K plan in the form of lost cash flow over a five year period.  This reduced cash flow has the effect of lowering the yield on your investment from something over 4.5% to something less than 2% for a five year period. It’s an investment nightmare.  Thanks, Uncle Sam.

Now, I’m sure the modification program will be utilized to help lots of homeowners who truly are at risk of default and foreclosure. But there will likely be hundreds of thousands of others who, in reality, required no assitance, and will reap a windfall at the expense of American taxpayers and private investors whose investment terms were modified by the federal government and the servicers.

Oh, and by the way. Do you know who the four biggest servicers are in the United States?  That would be CitiFinancial, Bank of America, Chase Bank and Countrywide (who is now owned by Bank of America), who just happen to already be the primary beneficiaries of huge sums of taxpayer bailout money.

This plan is ill-conceived, and absent restrictions (that have not yet been released) that prevent this type of abuse, will cost Americans and private investors trillions of dollars over the duration of the program.