The Obama Administration is Working on a Controversial Mortgage Refinancing Plan to Stimulate the Economy

In order to strengthen the housing market (NYSE:IYR), the Obama administration is working on a plan that would help a large number of homeowners and stimulate the economy, but cost the government next to nothing.

One of the proposals currently being discussed by the administration would allow millions of homeowners with government-backed mortgages to refinance at today’s lower interest rates, which are around 4%, saving them a cumulative $85 billion each year that they would then, hopefully, return to the economy through spending. But such a proposal would meet opposition from investors in government-backed mortgage bonds, as well as the regulator who oversees Fannie Mae and Freddie Mac.

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The administration is also discussing a home rental program that would prevent hundreds of thousands of foreclosed homes from flooding the market, dragging down housing prices. The administration has already requested ideas from the private sector on how to execute such a plan, which would meet far less opposition than widespread refinancing, but would have a decidedly smaller impact on the market and economy.

Many homeowners have been unable to refinance their loans because they owe more on their homes than they are worth, or because they have poor credit. The ability to refinance would decrease their financial burden, which would not only allow them to spend more elsewhere, but in some cases might be the difference between people being able to keep their homes and having them foreclosed upon. Thus refinancing could both buoy housing prices by decreasing the number of homes on the market, and stimulate the economy by giving millions of Americans more spending money.

Of course, housing experts across several federal agencies will decide which plan, if not both, they prefer, or may come up with entirely new ones, or decide upon no course of action at all. But refinancing does seem like a real possibility, despite opposition. Fannie and Freddie mortgage bonds have been trading well above their face value because so few people have been taking advantage of the current refinancing plan, but this week, those bond prices dropped in what could be an anticipatory response from investors.

If refinancing could reduce the number of homes being put on the market, it might reverse declining home values. One in five homeowners with mortgages now owe more than their homes are worth, and Wednesday the government reported that sales of homes with government-backed mortgages fell 5.9% in the second quarter from the year-earlier period.

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But the greatest impact refinancing could have would be on consumer confidence. While housing prices and interest rates are very low, fear is keeping consumers from taking advantage of what is most definitely a buyer’s market. “It almost seems to me you want to have some type of announcement or policy, program or something from the federal government that provides that clear signal that we are here supporting the housing market and this is indeed a good time to really consider buying,” said Frank E. Nothaft, chief economist at Freddie Mac.

Christopher J. Mayer, an economist at the Columbia Business School, says “This is the best stimulus out there because it doesn’t increase the deficit, it accomplishes monetary policy, and it reduces defaults in housing. Mayer and a colleague, Glenn Hubbard, who served as chairman of the Council of Economic Advisers under President George W. Bush, were the first to propose a version of the plan years ago.

The most appealing aspect of the plan is that it wouldn’t necessarily require Congressional action, which with a divided House and Senate, and a presidential election around the corner that is likely to have Obama’s opponents in Congress purposely hindering his ability to effect positive economic change, seems the only way the plan could be put into effect any time soon. However, despite party politics, Republicans might be willing to back the plan because it would not use any of the $45.6 billion in Troubled Asset Relief Funds set aside to help struggling homeowners. So far only $22.9 billion of that pool has been spent, and according to Treasury spokeswoman Andrea Risotta, whatever is left will be used to reduce the federal deficit.

Both plans are garnering support from very powerful entities. Investment firms support the rental plan, while banks prefer the refinancing plan, which also has the approval of Joseph Tracy, a senior adviser to the chairman of the New York Federal Reserve, and Richard B. Berner, who is the new counselor to Treasury Secretary Timothy Geithner. The plan’s proponents confirm that it would in many cases prevent default and foreclosure. Furthermore, the plan would carry little risk because the government guarantees the mortgages.

But none of that matters if the plan spooks investors, thus making borrowing more expensive in the future. And Edward J. DeMarco, who oversees Fannie and Freddie as director of the Federal Housing Finance Agency, says the plan could cost the companies money, which would in turn cost investors.