U.S. Foreclosure Mitigation: Too Little, Too Late? (Part 3)

In the first post in this series, I gave a very broad brush overview of the three government foreclosure mitigation programs that have been introduced since 2007. In the second post, we did a deep dive into the Home Affordable Modification Program (HAMP). In this post I’ll get into the Hope for Homeowners (H4H) program.

Although the point of both programs is to reduce the borrower’s payment-to-income (PTI) ratio, they get there in different ways. Whereas HAMP aims to reduce borrower monthly payments, H4H also aims to write down outstanding loan balances through the home’s current assessed value to extinguish any negative equity and give borrowers more “skin in the game”.

As I mentioned earlier, although HAMP has a lot of good things going for it, it falls short of a real solution to the foreclosure crisis because it only defers the affordability problem, and it leaves most distressed borrowers owing more than their homes are worth (i.e., “underwater”), and not very motivated to stay current.

However, in the short run, real solutions don’t come cheap, and for securitized loan holders, long-term solutions may not help if values decline so far so as to negate any interest in solving the problem? count for much. In the first post, I made a case for government coverage of the short-run costs, but dealing with the short-run interests of mortgage-backed securities (MBS) holders is a much thornier issue.

However, the HAMP has put forward some useful measures to try to ram through modifications (e.g., incentive payments to servicers and the legal safe harbor provisions introduced by Congress). These modifications must be potentially effective when MBS holders gripe about the program “allocating losses to some place that isn’t expecting it” and damage to the “sanctity of contract law” according to a recent Bloomberg article.

Anyway, the H4H program requires the lender to write distressed underwater loans down to 96.5 percent or less of the current appraised value until the 31 percent DTI is reached (see below for the exception to the 31 percent target). The lender also has to waive all prepayment penalties and late payment fees. These “short refinancings” are funded by new 30- or 40-year fixed-rate FHA-insured loans.

In addition to the DTI reduction requirement, H4H also requires that all debt payments (home and non-home) be at or below 43 percent of borrower gross income. (The 43 percent criterion is called a “backend” DTI, as opposed to the 31 percent “frontend” DTI.) For borrowers with higher debt loads, the frontend and backend DTIs can be expanded to 38 (and 50) percent, but, in such cases, the loan must be written down to 90 percent or less of current appraised value.

The lender also has to extinguish any junior liens. However, as I mentioned in the first post, in some cases, junior lien holders may try to abuse their position and hold things up, plus it may be difficult to track down and negotiate with the junior lien holder. In this regard, the Second Lien Program (2MP) announced on April 28 will be helpful. The 2MP pays [first lien?] servicers that extinguish second liens 3 to 12 percent (depending on various risk factors) of the loan balance.

The lender also has to pay a 300 basis point FHA up-front mortgage insurance premium (UFMIP), while the homeowner pays a 150 basis point annual premium. This is higher than the 225/55 basis point premia that the FHA usually charges on 95 loan-to-value (LTV) mortgages, presumably to cover the heightened riskiness of these particular new mortgages. (However, the “Helping Families Save Their Homes Act of 2009” (S.896), which the Senate passed on May 6, caps the premia at 200 basis points upfront and 100 basis points annually.)

In addition, if the homeowner sells the house or refinances the new mortgage, the government claws back some of the “instant” equity (100 percent in the first year, declining to 50 percent after five years), plus, if the property is sold, 50 percent of any net property value appreciation. (S.896 will allow for reductions in this clawback, but as far as I know, it’s still 50 percent.) Also, borrowers are prohibited from taking out new junior liens during the first five years, except when necessary to ensure maintenance of property standards.

In order to make this all more concrete, I’m going to run some numbers on the same hypothetical mortgage that I ran the HAMP through in the last post. It’s a seriously delinquent $200,000 10 percent 30-year loan on a property that was worth $250,000 at origination (an 80 percent LTV). The monthly payment is $2,380, including $625 of insurance and property taxes. The borrower’s gross annual income is assumed to be $57,120, to imply a current PTI of 50 percent.

The amount of writedown needed to get the PTI down to 31 percent will depend on the interest rates being offered on the FHA-insured refinancing, and the amount of home price depreciation (HPD) since origination (because the loan must be written down below the assessed value). Current 30-year FHA-insured mortgages are going for about five percent, so that a principal writedown to at least $158,468 would be required to obtain the needed DTI ratio.

However, an additional writedown may be necessary to get the balance down to 96.5 percent of current assessed value. The table below shows that in scenarios where home price depreciation (HPD) is zero and 25 percent, the writedown to $158,468 meets all H4H criteria. However, when HPD is 50 percent, a more extreme writedown is needed – to $120,625 at which the borrower DTI drops all the way to 26.7 percent. This suggests that the requirement to write the loan all of the way down to 96.5 percent of assessed value could be usefully dropped.

The next table compares these H4H refinancings to the expected net present values (NPVs) calculated in the last post for HAMP modifications and for doing nothing (“status quo”). It shows that the appropriate action/inaction is very dependent on the scenario – do nothing when HPD is zero, an H4H refinancing in the 25 percent HPD scenario, and a HAMP modification when HPD is 50 percent.

You might expect that business would be booming for both refinancing/modification programs, given the widespread negative HPDs. However, although the jury’s still out on HAMP because it just started up, H4H has generated very little business. Part of the problem with H4H is that it left implementation to under-resourced servicers, and placed the entire writedown burden on lenders. Hence, the $2,500 servicers will be getting for every completed H4H refinancing since April 28 may give the program a bit of a kick start.

Nevertheless, H4H will still be held back by a process that is quite convoluted from the borrower viewpoint. H4H requires the borrower to negotiate new deals with both original lender and the new FHA-approved lender. (Somewhat helpful in this regard may be the “pay-for-success” payments to the new lenders – up to $1,000 per year for up to three years while the new loan stays current, also introduced on April 28.) In addition, the future appreciation clawback and the rather high mortgage insurance rates could be putting borrowers off. Also, some homeowners are so deeply in debt, that no reasonable modifications can get the backend DTI below 43 or 50 percent.

It is possible that in some cases, the “pooling and servicing agreements” (PSAs) that govern the relationship between servicers and lenders block the most meaningful modifications, but very few actually do (e.g., see “what do subprime securitization contracts actually say about loan modification?”). Some say that servicer incentives tilt them towards foreclosures (“deleveraging the American homeowner”). Servicers have to keep advancing monthly principal and interest payments to lenders, even when the borrower is delinquent. They recover these advances only if the loan becomes current or when a foreclosure sale is completed. In the case of modifications, however, it could take a while to recover the advances, so servicers may prefer to foreclose.

Furthermore, servicers can find themselves caught between the sometimes competing interests of the different MBS tranche holders (“tranche warfare”). (For more on MBS mechanics, see Box 1 in “money for nothing”.) Basically an MBS slices and dices the performance of a pool of mortgages into “tranches”. As principal and interest payments come in on the underlying loans, the “senior” tranches get paid off first, and so on down the line to the “junior” tranches that effectively take the main brunt of any losses.

When a loan is foreclosed, the net proceeds flow immediately towards the early redemptions of some senior tranches, and a higher share of future principal and interest flows may be redirected to those tranches as well. All of this is effectively funded by the junior tranches.  On the other hand, modifications usually spread the pain across all of the tranches – cash flows to the junior tranches are reduced, and the senior tranches possibly downgraded. In the extreme case of principal writedowns, many of the junior tranches would likely have to be written off.

In any case, servicers caught in the middle of this “tranche warfare” and fearing lawsuits from aggrieved investors may not necessarily stick strictly to their NPV models. Regardless of the reasons, a recent research paper (“securitization and distressed loan renegotiations”) found that “securitization imposes significant renegotiation costs and a failure to renegotiate may have substantially contributed to the recent surge in foreclosures”.

This is where the aforementioned servicer subsidies are supposed to come in. It was also where the ill-fated bankruptcy “cramdown” legislation was supposed to come in. The idea was that, if bankruptcy judges were to be given the legal authority to write down principal balances on residential mortgage loans, servicers and lenders would be more eager to reduce principal balances voluntarily. However, S.896 includes a legal safe harbor provision for servicers that participate in the HAMP and H4H programs.

Time will tell if the servicer incentives, safe harbor, reduced FHA insurance premia and second lien subsidies will be effective in getting H4H refinancings off the ground. In the next and final post in this series, I’ll sum up these two programs and try to identify some possibly better ways forward.

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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.

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