Not Everyone Benefited from Lower Interest Rates During the Great Recession

The strategy sounds great on paper. But does it always work? Or might lenders’ policies, however well-intentioned, undermine the Fed’s efforts?

Anthony DeFusco and John Mondragon, assistant professors of finance at the Kellogg School, tackled this question, looking specifically at mortgage-lender regulations during the Great Recession. They found that, instead of making it easier for people to get mortgages at lower rates, some lending policies actually made borrowing more difficult, especially in a recession.

As the housing market collapsed, the Federal Housing Agency (FHA) got nervous about potential defaults and began instituting new policies for borrowers trying to refinance their FHA mortgages. For example, borrowers were required to provide information about their employment status and income, and unemployed borrowers were no longer allowed to refinance. The FHA also instituted new upfront refinancing costs for “underwater” borrowers whose homes were worth less than the amount they still owed on their mortgage.

These policies were in line with rules that other large institutions, such as Fannie Mae and Freddie Mac, had always imposed. By studying the FHA change, the researchers were able to zero in on the impact that these sorts of policies have on people’s ability to refinance during a recession.

DeFusco and Mondragon find that when access to loan refinancing was constrained by these more stringent rules, the benefits of lower interest rates failed to reach those households who most needed it—those who, because of the recession, suddenly had less savings and income.

This has serious, negative implications for families, and for the broader economy.

“Our research shows that imposing income or employment conditions effectively excludes those segments of society who would benefit most from lower interest rates,” Mondragon says. “This could undermine the stimulating effects of monetary policy. Households suffer, recessions can last longer and, because many mortgages are federally insured, the U.S. taxpayer is ultimately left with a heftier bill to pick up.”

The Great Recession and Mortgage Refinancing

DeFusco and Mondragon focused their research on the FHA Streamline Refinance (SLR) program.

Before the program’s policy change in September 2009, the SLR allowed borrowers with an existing FHA loan to refinance their mortgage without documenting their employment status. Additionally, out-of-pocket closing fees could be rolled forward into the restructured mortgage payments instead of paid upfront. After the policy change, all borrowers were required to document their income and employment, and closing fees would have to be paid out of pocket for underwater borrowers.

The changes were implemented in hopes of reducing default rates on new loans, the cost of which would be shouldered by the FHA and, ultimately, the taxpayer, as these loans are guaranteed by the government.

Were borrowers whose savings and income had taken a hit—presumably those most in need—able to refinance their mortgages after the change? Or did the new upfront costs and employment documentation act as an obstacle?

To find out, the researchers looked at loan-performance data before and after the 2009 policy change. Using detailed data from the Guthrie Real Estate Center at Kellogg, they tracked refinancing across a group of approximately 1.3 million loans six months before and six months after the rule change. (A control group of non-FHA borrowers unaffected by the change was also analyzed for comparison.)

The Impact of Refinancing Restrictions

The researchers found that the rule change had a significant impact.

“Overall, refinancing rates in the FHA market drop off as soon as the policy change goes into effect,” DeFusco says. Together, the researchers find that the two new constraints led to a 50% reduction in refinancing among FHA borrowers.

And, importantly, the new requirements did not affect all households equally.

The researchers compared data on refinancing rates among FHA borrowers with data on unemployment rates in each U.S. county. They show that the drop in refinancing is substantially larger in counties that experienced large increases in unemployment during the recession.

These numbers imply that if unemployed borrowers—whom most lenders had not allowed to refinance, even before the housing crisis—were given the ability to do so, they would refinance at monthly rates that are almost 5 times higher than the rate among employed borrowers.

At the same time, there was the issue of upfront, out-of-pocket costs, which Mondragon and DeFusco looked at separately.

To study this, they compared refinancing rates for FHA borrowers who were and were not underwater on their homes, since only those underwater had to start paying for closing costs. They found a drop-off of more than 50 percent in refinancing among borrowers who were forced to pay for fees out of pocket relative to those who were not.

“For low-income families, this is a significant barrier,” DeFusco says. “This becomes a very big ask in those households where money is already tight.”

Mondragon adds: “The households who stand to benefit most from lower borrowing rates are the very ones that are being pushed out of the equation by these mechanisms.”

Wide-Ranging Implications

Mondragon and DeFusco say their findings have wide-ranging implications for households, the broader economy, and taxpayers.

Previous research shows that homeowners who are able to borrow at lower rates are less likely to default on their mortgage, less likely to face foreclosure, and more likely to make new, large purchases.

“If you can’t refinance because of low income or unemployment, you may be forced to sell or lose your home. The effects can be devastating for a household’s financial health,” Mondragon says. “Even those who managed to keep their home were likely forced to make painful cuts elsewhere.”

And the impact on the broader economy is the exact opposite of what policymakers would hope for.

“As people have less disposable income, you get this negative loop where less demand today means a reduction in spending, which leads to further decreases in demand and spending tomorrow,” DeFusco says. “So what we’re seeing is that in squeezing access to credit and refinancing options, you are actually inhibiting the ability of monetary policy to effectively respond to recessions.”

Additionally, he says, because those who are among the most in need of help are hardest hit by these rules, “you can argue that these policies amplify societal and economic inequality.”

Then there’s the burden to taxpayers.

The vast majority of the U.S. mortgage market is guaranteed, either explicitly or implicitly, against default by the government. It is therefore in the taxpayer’s interest to make it easier for people to avoid defaulting on their mortgages in times of economic stress.

“So in public-policy terms, there should be a real interest in helping people overcome obstacles to borrowing at reduced rates,” Mondragon says.

Looking Ahead to the Next Crisis

While the research uses data from 2009, the results could potentially be extrapolated to any scenario in which interest rates are lowered to spur liquidity and growth.

“The Fed should be looking at this and thinking about the implications for monetary policy,” DeFusco says.

At the same time, he says, the mortgage industry should think about how to design better contracts that permit households to refinance when they suffer unemployment.

“Maybe we need to be building in more flexibility,” he says, “which would be good not just for households but for everybody.”