Yves Smith and Adam Levitin, for whom I have enormous respect, argue that allowing underwater borrowers to refinance their mortgages at lower rates would not help the housing market very much. I am not so sure.
Consider a borrower with a six percent mortgage whose house is worth 80 percent of the mortgage balance. Let's also say that it is four years into its mortgage--so it has 26 years remaining on its term. If house prices remain flat, it will be 11 years and 9 months before the mortgage balance drops to the value of the house.
Suppose we were to convert the mortgage to a 4.5 percent mortgage but left the mortgage payment the same. In the first month, the amount of principal payment would increase by 2.35 fold. The borrower would be above water in 5 years and 5 months (I have a spreadsheet with the calculations, should anyone be interested). If house prices rise by two percent per year, the 4.5 percent borrower would be right-side up in less than four years. Helping borrower see a light at the end of the tunnel could really make a difference (I don't see borrower in Las Vegas ever seeing that light, but not everyone is in Las Vegas).
Personally, I would rather see some principal reduction too, but allowing free refinancings on Fannie and Freddie mortgages could materially benefit the housing market.
