By John Kiff*
As U.S. home foreclosure rates rise to levels not seen since the Great Depression, government policy has consistently been too little, too late, and frankly, off target. In this series of posts, I’m going to do a fairly deep dive into the “end game” of the current mortgage crisis. (The “opening” and “middle games” have been well documented elsewhere – e.g., “Money for Nothing“.) In this first post, I’ll give a very broad-brush overview of the three government foreclosure mitigation programs that have been introduced since 2007. Then, I’ll talk about some of the reasons why they have failed (or are likely to fail).
FHASecure (introduced in 2007) and Hope for Homeowners (H4H, 2008) were designed to encourage lenders to write loans off in return for 90 to 97 percent of appraised home values. However, only about 4,000 loans were refinanced under FHASecure before it was closed down at the end of 2008, and less than 1,000 homeowners have applied for H4H short refinancings. These two programs failed largely because they left implementation to under resourced servicers, and placed almost all the writedown burden on the lenders and investors.
The more recent Home Affordable Modification Program (HAMP, 2009) rectifies these shortcomings by offering various incentive payments to servicers and lenders (investors in the case of securitized loans). The point of the program is to encourage servicers to avert foreclosures by offering loan modifications that reduce monthly payments to more affordable levels. However, unlike FHASecure and H4H, HAMP is not designed to encourage principal writedowns, a problem I’ll discuss later. (HAMP’s incentive payments will apply to H4H refinancings, but in most cases servicers will opt for temporary payment reductions rather than H4H’s principal writedowns.)
It seems fairly obvious that, to be effective, loan modifications should reduce monthly payments. But according to the most recent OCC and OTS Mortgage Metrics Report, some servicers still don’t get it, although they are starting to:
Not surprisingly, the OCC/OTC report confirms the lower redefault rates on modifications that reduce payments:
In fact, a recent paper by Quercia, Ding and Ratcliffe goes even further, and finds “an even lower likelihood of redefault when the payment reduction is accompanied by a principal reduction.” Given this evidence, it is somewhat surprising that HAMP wasn’t designed to encourage principal writedowns on “underwater” loans (where the home’s value has depreciated below the outstanding mortgage balance, including junior liens).
You might wonder why government intervention is needed to incentivize mortgage servicers to offer payment-reducing modifications in the first place. One reason is that some of the agreements that set out what the servicer can and cannot do (i.e., the “pooling and servicing agreements” or PSAs) limit the number of modifications (although most do not). Also, most PSAs give little explicit guidance as to what kinds of modifications are acceptable or not, so foreclosure often becomes the “better safe than sorry” option. (For much more detail on the economics of servicing, see “foreclosure mitigation efforts“.)
Another problem is the cost of dealing with junior liens. About 25 percent of subprime mortgages currently outstanding had a junior (“piggyback”) lien at origination, and about 40 percent do when home equity lines of credit are considered, according to the Congressional Budget Office. In principle, significant loan modifications can demote the first lien to a junior lien. However, this puts the previously senior lien holder in parity with the original junior lien holder, unless the original junior lien holder agrees to re-subordinate (drop his lien even further down). Hence, first lien holders generally require junior lien holders to agree to re-subordinate their claim before agreeing to modifications. However, in some cases, junior lien holders may try to abuse their position and hold up modifications. Furthermore, unless both the senior and junior mortgages are serviced by the same company, it may be difficult to track and negotiate with the junior lien holder.
Furthermore, about 80 percent of all nonprime loans, which comprise the vast majority of distressed mortgages, have been securitized and tranched into mortgage-backed securities. Modifications that benefit some tranches often compromise others, and sometimes leads to “tranche warfare.” For example, temporary payment reductions tend to spread their impact across all of the tranches, but principal writedowns can wipe out the junior tranches. Hence, for example, the (mostly) hedge funds that hold junior tranches have been threatening litigation, especially if the writedown process is mechanical or “streamlined” (rather than case by case).
Finally, modifications that reduce monthly payments may just be uneconomical from the servicer/lender perspective. According to the American Securitization Forum, “in evaluating whether a proposed loan modification will maximize recoveries to the investors, the servicer should compare the anticipated recovery under the loan modification to the anticipated recovery through foreclosure on a net present value basis.” In some cases, the homeowner just can’t afford even the most drastically cut monthly payments due to insufficient income and/or other debts and obligations. Also, in areas of extreme home price depreciation, foreclosure may be NPV-maximizing (versus principal writedowns on underwater loans and/or bringing debt-to-income ratios down to reasonable levels).
Government intervention can play a useful role in providing incentives for foreclosure mitigation, due to the negative feedback loop and vicious circle effects of mass foreclosures (see “foreclosure mitigation efforts“). However, detractors point to the unfairness of bailing out irresponsible homeowners, in addition to the practical problems outlines above. That’s a fair point, but foreclosed properties stay unoccupied for extended periods of time, deteriorating and often inviting vandalism, thereby pushing down home values in the immediate neighborhood. As such, it seems in everyone’s best interest to incentivize foreclosure mitigation. As Fed Chairman Bernanke put it in an appearance on “60 Minutes” in March:
If you have a neighbor, who smokes in bed. And he’s a risk to everybody. If suppose he sets fire to his house, and you might say to yourself, you know, ‘I’m not gonna call the fire department. Let his house burn down. It’s fine with me.’ But then, of course, but what if your house is made of wood? And it’s right next door to his house? What if the whole town is made of wood? Well, I think we’d all agree that the right thing to do is put out that fire first, and then say, ‘What punishment is appropriate? How should we change the fire code? What needs to be done to make sure this doesn’t happen in the future? How can we fire proof our houses?’ That’s where we are now. We have a fire going on.
Nevertheless, while HAMP puts forward some very useful incentives for servicers to offer temporary payment reductions to distressed borrowers, it may only be deferring the impact of the underlying underwater loan (or “negative equity”) problem. In the next post in this series, I’ll delve into some of the more gory details of the program, plus those of the still-active H4H program, to show how these two programs can be merged into something more effective from a longer-term perspective.
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* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.