One year after the government officially took control over Fannie Mae and Freddie Mac, that is the question everyone is asking. The companies have racked up a combined $165 Billion in losses over the last couple years, and already burned through $100 Billion in taxpayer-financed aid. Altogether, the government now has $400 Billion exposure to Fannie and Freddie.

It’s quite clear that something has to be done. A new report by the Mortgage Bankers Association (MBA) recommends that the two companies be split into three smaller entities and continue to perform the same role that they do now. Under the proposal, the new firms would bear all of the direct risk from owning/underwriting mortgages, but would still enjoy some form of government guarantee. It’s not clear how this structure would facilitate stability, though it would probably increase transparency.

An unrelated report by the Government Accountability Office (GAO) examines the three options for Fannie and Freddie without actually offering an opinion as to which one is most advantageous. It is quite critical of the MBA proposal, arguing that “Creating ‘reconstituted’ for-profit government-sponsored enterprises, either publicly traded or owned by lenders, ‘could lead to even greater moral hazard. ‘ ” The alternatives – elimination, privatization, or full government takeover – however, are equally fraught with complications. Without Fannie and Freddie, it’s unclear how the mortgage markets would function, while a government takeover would probably result in a downsizing of their lending portfolios.

Before I continue, I want to stop and explain the role that Fannie and Freddie play in mortgage lending. Namely, the two firms act as liquidity providers, by using shareholders’ equity to purchase huge portfolios of securities mortgages (Mortgage-Backed Securities). And when I say huge, I mean it: “The companies, which own or guarantee about $5.4 trillion in U.S. residential debt and have accounted for about 70 percent of all new home loans this year.” By acting as the largest buyers, they enable mortgage lenders at the ground level to originate new loans, confident that they can be quickly repackaged and sold.

At this point, it seems the most likely scenario is that which was proposed by the MBA. It’s hard to understand how this represents a solution, but I guess it’s like the old joke about democracy: “It’s the worst system, except for all the others.” In other words, Fannie and Freddie have become the fulcrums of the mortgage lending industry, so their disappearance would be accompanied by a massive decline in new mortgage origination.

There are certainly analysts and policymakers that would argue this is a desirable outcome. The government has no business – explicitly or implicitly – playing with mortgages. If the government formally exited the mortgage lending industry (except to serve as regulator), it would probably lead to better risk management, since investors would have to assume the full risk of owning mortgage backed securities.

In addition, some of the slack caused by their disappearance would probably be picked up by private investors, since a portion of the capital currently invested in Fannie/Freddie would presumably be diverted to firms with similar interests. At the very least, it seems lending standards would tighten and interest rates would rise, but both of these phenomena have already started to obtain.

From the standpoint of current mortgagers, this won’t affect you much. Refinancing could prove more complicated, but it wouldn’t affect the terms of your current loan. For potential borrowers, it would most likely make it both more difficult and more expensive to obtain a mortgage. It’s tempting for me to urge you to preemptively go take out a mortgage lest the system changed tomorrow, but this is extremely unlikely, as the GAO estimates ” ‘potentially lengthy transition’ given their size.”

In other words, don’t let this affect your decision one way or another.

Over the last couple months, mortgage rates have beaten a steady decline, down to 5.4%, according to the latest Freddie Mac Weekly Primary Mortgage Market Survey. That marks a tremendous drop – relatively speaking – from the 5.59% notched in June.

The rate quoted above is the 30-year fixed rate, the benchmark of mortgage rates. It should be noted that this is a raw figure, as provided to Freddie Mac directly from mortgage lenders based on the rates paid by their customers. In this case, the average borrower paid .6 points to buy the rate down, which means that the par rate is actually higher. In other words, even if you have perfect credit, you can probably still expect to either pay a higher rate or pay a higher upfront fee.

Meanwhile, variable rate are currently running around 4.5% . If you opt for a 15-year fixed rate mortgage, you can expect to pay 4.46% interest (and .6 points). From this, you can see that the spread between 15-year and 30-year rates is a healthy .58% . In addition, since this lower rate is also spread over a shorter time period, the aggregate savings on interest will be significant over the life of the mortgage. (As an aside, there are other considerations in selecting a mortgage with a shorter term, namely whether or not you can afford the higher monthly payments. Especially given the current economic environment and the uncertain labor market, this is an important consideration.)

There are also wide regional differences concealed in the average figures reported by Freddie Mac, which can sometimes vary by as much as .3% from state to state. Recently, rates in the most distressed markets have tended to be lower than in healthier markets. This is perhaps explicable by lower demand for mortgages in states that have been hit hardest by the bursting of the housing bubble.

So, why have rates headed downwards? As I alluded to in the title of this post, it’s not for the most obvious reasons. In fact, mortgage activity is actually rising: “A four-week moving average that tracks mortgage application activity is up 1.7% overall.  Among refinance applications, that index is up 2.1%, while it’s up 1.2% for mortgage purchase applications.” In this case, an increase in demand hasn’t resulted in an increase in prices.

The reasons are manifold, but can mostly be found outside of mortgages/housing. For example, the Federal Reserve Bank has resumed its purchases of mortgage-backed securities (MBS) in recent weeks, as part of its program to stimulate both the housing market and the broader economy. Given that average mortgage rates rose when the Fed stopped buying MBS, and fell when the Fed started again, it’s obvious that this is an important factor. Another explanation can be found in US Treasury prices, which tend to lead mortgage rates up and down. Recent fears of a prolonged economic recession, low inflation, and a period of continued low interest rates have caused Treasury rates to sag ever closer to the all-time lows of 2008. Investors in MBS – from which the vast majority of mortgage rates are derived – seem to be taking their cues from low Treasury markets, and are buying MBS rates down proportionately.

Whether rates remain low, then, depends directly on the Fed and MBS investors. It seems unlikely that the Fed will continue to buy MBS in bulk, since all of those securities will have to be sold when the recession comes to an end. On the other hand, it’s conceivable that demand for Treasury bonds (and

MBS, by extension) will remain strong for as long as the economy remains weak. Still, as I wrote in the previous rate update, it doesn’t seem likely that rates will trend much lower, which means there’s no reason to delay if you’re thinking about taking out a mortgage or refinancing.

In light of the credit crisis, the calculus that goes into buying one’s first home as changed. The old logic of bigger is better no longer applies. The new rules emphasize careful planning, conservative forecasting, and frugality.

First of all, no longer can/should you assume that your home will appreciate indefinitely, if at all. This erroneous assumption is one of the biggest factors in the current wave of foreclosures, as mortgagers took out mortgages that were larger and riskier than otherwise advisable because they believed that they would be able to ultimately sell the house for profit.

In hindsight, the opposite proved to be true, and millions of homeowners now find themselves with underwater mortgages. In short, don’t think of your home as a conventional investment that will yield a return when it’s ultimately disposed of. A home has utility (which includes intangible value), and this should be the biggest factor in the purchase. Along the same lines, you need to consider that if your home does appreciate (or even maintain its value) it will require substantial upkeep, perhaps to the tune of 4% a year. While maintenance will provide an emotion return in the form of increased comfort/satisfaction, it will likely negate most, if not all of the financial return that will earn from owning your home.

Second, don’t make overly optimistic assumptions about future earnings, which could potentially leave you with a crushing debt burden in the even that your income doesn’t grow as planned. DINKs (Double Income No Kids) might think of themselves as the exception to this rule, because they are best in position to gamble. At the same time, this is somewhat irresponsible, since such individuals are most likely to witness their costs (kids….) increase faster than their income. This rule is especially important in the current economic environment, with income growth projected to be flat, on average, for the next few years.

The third piece of advice is to think small. When in doubt, go with the smaller home/mortgage. If your financial situation changes for the worse, you will be glad that you did. If, on the other hand, your financial situation improves, you can always upgrade to a larger home. In this case, a viable option is to simply expand your home, which will probably prove less costly, inconvenient than moving.

Along the same lines, you may want to consider taking out a “conservative” mortgage. Generally, this means going with a 30-year fixed rate mortgage. It could mean higher rates in the short-term, but there won’t be any surprises over the long-term. You will know from Day 1 exactly how much you will need to pay each month, regardless of whether home prices or interest rates change. In addition, bear in mind that a down-payment of more than 20% of the value of the home is least likely to lead to an underwater mortgage down the road. Hewing closely to your lender’s recommended income and asset ratios also makes it less likely that you will overextend yourself.

Finally, remember that there is an advantage to being a first-time homebuyer right now, in the form of a government tax credit. Ideally, you should consider the affordability of your mortgage irrespective of the credit, in which case your financial position will be especially robust. Still, human nature being what it is, I suppose you can’t be faulted for factoring in the government’s contribution to your down-payment. For some borrowers, the government’s 10% (maximum $8,000 contribution) could even eliminate the need to make a down-payment altogether. Bear in mind that time is running out on this program; while the federal government is mulling an extension, it is currently scheduled to expire on December 1. With potentially only two more month left, now’s the time to start filing the paperwork!

Here at the Mortgage Calculator, we try to provide timely updates on the government’s loan modification program. Our last post, on August 6, (”Loan Modification Program could Receive Boost“), detailed the program’s shortcomings, which were responsible for the program’s dismal 9% participation rate. Since then, we’re happy to report that the program has really taken off, as the largest lenders have been shamed by the federal government into submission.

According to Bloomberg News, “Bank of America Corp. and Wells Fargo & Co., among the worst performers of banks in the U.S. government’s main foreclosure prevention plan, stepped up their pace of mortgage modifications by at least 60 percent in August.” Leading the pack is Morgan Stanley’s mortgage origination unit, which has modified over 40% of eligible loans, defined as owner-occupied homes, with a pre-2009 conforming mortgage that is in danger of “imminent default.”

As always, the devil is in the details, since a loan modification doesn’t necessarily lower the risk of default, and doesn’t even translate into a lower payment. “Of loans modified from Jan. 1, 2008, through March 31, 2009, monthly payments increased on 27% and were left unchanged on an additional 27.5%…Many modified mortgages fall delinquent — 25% to 40%, depending on the type of mortgage — often because of homeowners’ loss of income or additional outstanding debt…”

There are a few reasons for these outcomes. First of all, when executing loan modifications, lenders can choose between lowering one’s interest rate (temporarily or permanently), extending the loan term, and cutting principal from the loan amount. In theory, all would seem to lead to lower payments, but as the statistic above attests to, this is the case less than half the time, due primarily to the adding back of deferred taxes. Astonishingly, over 90% of loan modifications lead to higher principal balances.

Advocates argue that this represents the best approach. They point out that mortgage problems for many are a temporary result of unemployment, rather than long-term financial hardship. “A lot of what’s being done is a misplaced focus on modest, long-term relief when what they need is fast, short-term, massive relief (due to job loss),” maintains one economist. This philosophy is reflected in Bank of America’s approach to loan modification, which offers “mortgage forgiveness for three to six months in hopes the borrower will find a new job in that time.”

Those on the other side of the debate argue that this misses the point, and that the focus instead should be on “permanent debt reduction.” Many have begun to direct their attacks on the industry’s Net Present Value model, which is used to asses whether a loan modification is ultimately in the best interest of the lender. According to critics, this model is overly conservative, and leads to an overly high rate of rejection. At the very least, it confirms what cynics have maintained all along- that the mortgage lending industry still does not remain behind the loan modification program.

There’s even a small minority of critics who insist that loan modifications are a bad deal, on the grounds that it damages the credit of borrowers. “Under reporting guidelines set forth by the credit bureaus and the Consumer Data Industry Association, your loan modification will be reported as a ‘Partial Payment Plan.’ Under the FICO scoring method, that designation will lower your credit scores, even if you have never missed a payment.” From a credit standpoint, then, loan modification is not much different from foreclosure that far away from foreclosure, and might ask some to consider whether the consequences justify it.

Outside of this debate are the millions of people still waiting to receive modifications. For every borrower that is emerged “victorious” from the maze of requirements, there are at least 10 more who are stuck in “loan modification hell,” as one columnist put it. Anecdotal reports indicate that the experience is both time-consuming and frustrating; the best advice is to be patient, and to keep a paper-trail.

Option Adjustable Rate Mortgages (ARMs) were just one of many innovative financial products that rose to the fore during the housing bubble. They work by enabling borrowers to select from three options, the size of the payment they wish to make on their mortgage each month. The high payment is fully-amortizing (principal and interest), the middle payment is interest only, and the low payment is a token sum which does not even cover interest. That the bast majority such borrowers opted to make the low payment has led to the characterization of the Option ARM as the Negative Amortization ARM.

Many ARM borrowers actually caught a break after the housing bubble burst, since the consequent lowering of interest rates brought ARM rates down proportionately. Gushed one borrower, whose rate is tied to LIBOR, ““In 2009 I found out I have a 2.5 percent mortgage. That’s not onerous by any standards.” Unfortunately, lower interest rates doesn’t necessarily translate into lower payments.

There is a clause in most Option ARM contracts which states that if/when the loan reaches 60 months in age and/or the balance reaches a cap (110% – 125%), the loan automatically recasts. Essentially what this means is that the borrower must begin to make fully amortizing principal and interest payments; the minimum negative amortizing payment is no longer an option.

Due both to the decline in housing prices and the fact that most Option ARM borrowers elected to make the lowest payments, recasts are beginning to rise. 2011 meanwhile, will likely witness an explosion in recasts, as loans cross the 60-month time limit. According to a recent report by Fitch Ratings, this figure could be as high as 70%. Moreover, “Of the $189 billion securitized Option ARM loans outstanding, 88% have yet to experience a recast event. Of these loans that have not yet recast, 94% have utilized the minimum monthly payment to allow their loans to negatively amortize.”

For a significant portion of Option ARM borrowers, a recast is tantamount to a death sentence. Fitch predicts that ultimately, close to half of such borrowers could default on their mortgages. “They’re probably going to default at a rate that makes subprime look like a walk in the park,” warned one analyst. When you consider that as much as 14% of outstanding mortgages are Option ARMs and that most were used to purchase homes in bubble markets (California, Florida, Nevada, Arizona), the losses will probably be staggering.

Ironically, holders of Option ARMs don’t have many Options when it comes to mitigating the burdens posed by their mortgages. While refinancing could save money over the long-term, it would probably won’t help those who are currently struggling: “Just about anything they refinance into is going to give them higher payments than they have now,” explained one counselor.

Mortgage modifications, meanwhile, are also pretty much off the table, since they are intended to lower one’s mortgage rate rather than to lower one’s payment, directly. ” ‘The problem with these option ARM borrowers is they are already paying a low rate,’ [Barclays Analyst] Deb said, adding that a better solution would involve forgiving part of the loan balance, something that most lenders have been unwilling to do.” Still, if you’re facing such a predicament, it wouldn’t hurt to talk to your lender. As the problems surrounding Option ARMs become more prominent, lenders might become increasingly keen to play ball.

Anyone who has done any research into taking out a mortgage has surely heard of points, but based on the feedback of our readers, few seem to actually understand how the points system works. In a nutshell, points refers to paying an upfront cash payment in exchange for a lower interest payment (and lower monthly payment, by extension). It is also possible to receive a rebate (negative points) in return for paying a higher interest rate.

Many lenders take advantage of (borrower misunderstanding of) points in order to make it look like their interest rates are lower than their competitors, when in fact the difference can be explained entirely by the points. On the surface, paying points would seem like a great option, since mortgage affordability is generally calculated backwards, using monthly payment – rather than the size of the mortgage – as a starting point.

In this way, the numbers can be manipulated, such as to make it so a potential borrower can afford a larger mortgage simply by extracting an upfront payment in exchange for a lower monthly payment. Of course, this can also be achieved by simply increasing the size of one’s down-payment, but yields slightly different savings. Generally speaking, a higher down-payment is more economical in the short term, while using points to buy down the rate is only beneficial over the long-term.

So, how can you go about calculating whether it makes sense to pay points? This Points Calculator makes this question easy. Simply plug in the loan amount, points, interest rate, interest rate with points, loan term, and a realistic return on investment, and the calculator will quickly generate a break-even point- the amount of time it will take before you can achieve positive savings on your mortgage.

In other words, the points system inherently favors the bank over the short-term. It’s impossible to achieve savings from Day 1. Instead, you must plan on living in your home (and keeping your current mortgage) for a certain number of years before paying points becomes worthwhile. If you have every reason to believe that you will stay in your home longer than the break-even period, then it makes sense to pay points. Instead, if you plan on refinancing or “trading up” before the break-even period, it probably makes more sense to simply increase the size of your down-payment.

Another consideration is whether to roll the points into your mortgage, in order to avoid making a large up-front payment. This will significantly extend the break-even period and is only economical if your savings rate (i.e. expected return on investment) is higher than your mortgage rates, and your marginal tax rate is low. The latter is a factor because financing your points allow the tax benefit to be amortized over the life of the mortgage, while an upfront payment can only be deducted in the year in which it is paid.

Finally, it’s possible to temporarily buy-down your mortgage payment, such that you pay a lower rate for only a few years. The 2/1 buy-down and 3/2/1 buy-down are the most common and straightforward, with the latter reducing your interest rate by 3% in the first year, 2% in the second, and only 1% in the third year, before reverting to the stated rate. Typically, you shouldn’t expect to achieve savings from a temporary buy-down; rather the perceived benefit is that you can delay the normal payment for a couple years, giving your income a chance to catch-up.

When filing a mortgage application, you will be required by your lender(s) to submit certain documentation, in order to prove both your income and your assets. While your lender will most likely inform you of specific requirements, you can save yourself precious time by preparing all of the documents in advance.

In terms of proof of assets, you should begin by compiling information on all of your bank accounts, including account numbers, the branch address(es), and copies of recent statements. Remember to include information for both checking and savings accounts. You should also plan on furnishing statements of other liquid assets, such as IRA retirement accounts, CD’s, annuities, and estimated cash value of life insurance policies. It wouldn’t hurt to provide valuations for Illiquid assets (real estate, valuables).

The next step is to document your income. This is best achieved through the provision of pay stubs, W-2 withholding forms, and even recent tax returns. If you are self-employed, you should prepare audited income statements for your business. Generally, lenders won’t require more than two years worth of data, but in some cases, they may request additional information.

Even if your creditworthiness has been established (and especially if it isn’t), it wouldn’t hurt to show timely payment of rent and utilities for the last 1-2 years. Your lender will also need to see and legal documents/filings (related to divorce, etc.) in order to determine if any potential liabilities exist.

Prior to the bursting of the housing bubble, it was possible to obtain a competitively-priced loan without providing any or all of the documentation listed above. Reacting to lending standards that were perhaps overly stringent, lenders gradually loosened their requirements. This led to lender complacency and the consequent proliferation of so-called liar-loans, which describe mortgages that require little or no documentation.

In some cases, it is still possible to obtain such loans. Some lenders will accept stated income and/or assets (as opposed to verified income and assets), but you can expect the spread to full documentation loans to be higher than before. According to a recent report, “Less-documented borrowers who reported high incomes were far likelier to default than those whose high incomes were verified – suggestion that loans were made on misleading information.” The report found that applicants were likely to overstate income by 20% on average when verification wasn’t required.

For some applicants, namely those who are self-employed or in-between jobs, a low-documentation loan might still be the best choice. No-ratio loans, whereby income and assets are verified but not used to calculate typical do-not-exceed ratios, might be necessary for those who want to purchase houses that are technically unaffordable.

Of course, you should speak to a loan officer before deciding whether a low-documentation loan is appropriate for you, but it helps to know your options before going in.