Economists have been debating the value versus risk of expanded refinancing opportunities since the early days of the housing crisis. Proponents argue that refinancing would free up homeowner money for spending elsewhere to the benefit of the economy, opponents fear that since the Federal Housing Administration and the government sponsored enterprises (GSEs) are realistically the only source of refinancing currently available, any risk inherent in refinancing will disproportionately fall the government. 

To clarify an issue that is of interest to homeowners, policy makers, and taxpayers, the Federal Reserve Bank of New York has just published a report, Payment Changes and Default Risk:  The Impact of Refinancing on Expected Credit Losses by staff members Joshua Abel, Joseph Tracy, and Joshua Wright that looked at whether refinancing lowers the risk of default.

Earlier studies have looked at defaults after loan modifications which reduce rates and/or payments.  One study found that for a sample of modifications to securitized subprime mortgages a 10 percent reduction in the monthly payment was associated with a 4.5 percentage point reduction in the 12-month redefault rate.

Extrapolating earlier studies to suggest that expanding the government's Home Affordable Refinance Program might result in lower defaults is suspect because the one study mentioned concerned only subprime borrowers while HARP involves prime borrowers with much stronger initial credit profiles and those borrowers who were given modifications were already seriously delinquent while HARP requires homeowners to be current with a relatively clean payment history over the previous 12 months.    

The ideal study would link together the prior mortgage with the HARP-refinanced mortgage so that one could measure the percent reduction in the monthly payment and estimate how HARP impacts the likelihood that the borrower will default on the refinanced mortgage. With such a linked HARP mortgage data set, one could control for other important factors, such as the borrower's updated loan-to-value (LTV) ratio, when estimating the impact of the payment change on the default risk. However, no such linked data set on HARP-refinanced mortgages exists, making it difficult to estimate the effect of lower monthly payments on the population of HARP-eligible borrowers.

The New York Fed study approached the issue by studying the impact of refinancing adjustable rate mortgages (ARMs).  While these are significantly less common than fixed rate mortgages, this methodology provided some advantages for estimating the impact of refinancing on fixed-rate borrowers such as allowing the researchers to compare similar borrowers in terms of their credit profiles when their mortgages were originated.  As rates have dropped, the rate resets on many ARMS resulted in lower monthly mortgages payments, mimicking refinances, and the percentage reduction in the mortgage payment from origination date to the most recent reset date can be used to help explain subsequent default behavior by the borrower.  This approach also addresses the issue of pre-existing delinquency raised by using mortgage modifications in a study.

The authors used a sample of over 173,000 prime ARMS originated since 2003 and on which there were an aggregate of 6.5 million monthly payments and controlled for a number of factors that might affect a default rate such as the original FICO score, the updated LTV ratio, employment data, and home price changes.

Focusing on borrowers with an updated LTV of 80 or higher who would be candidates for refinancing under the HARP program, the authors found that a 26 percent reduction in the monthly mortgage payment, which they estimated would be the average reduction through a HARP refinancing, would result in a 3.8 percentage point reduction in the five-year cumulative default rate. Combining this with an estimate of the likely losses given a default on these mortgages, the results indicate that borrowers who refinance under HARP have an estimated reduction in projected credit losses of 134 basis points, or for every billion dollars in agency mortgage balances that refinance through an improved HARP, the estimated reduction in credit losses would be $134 million. This reduction would primarily benefit taxpayers, although private insurers of the underlying mortgages would also receive some benefit.

The authors note that enhancements such as removing the previous 125 percent LTV ceiling were made to HARP last October and further enhancements are being debated.  They argue that improving HARP will provide benefits to the economy by increasing the disposable income to households that refinance and saving taxpayers money by reducing credit losses by Fannie Mae and Freddie Mac.