Friday’s announcement that the administration is overhauling its mortgage modification program to encourage principal forgiveness shows they understand that unless folks have equity in their homes, mortgage defaults will continue in huge numbers. The plan is a decent one, and it appropriately would have lenders absorb the lion’s share of losses. Still, its an all-carrots approach that may be tough to get off the ground. And taxpayers would get even more deeply involved in housing finance.
If it doesn’t work, regulators have a stick to force lenders to take losses, which I describe at the end.
First, let’s consider the size of the foreclosure problem. I chatted with Sean Dobson, CEO of Amherst Securities, and he quantifies the foreclosure crisis as 12 million at-risk households. Seven million have already stopped paying their mortgage, another five million are so deep under water, they likely will. Meanwhile, only 1.5 million homes have been liquidated, that is, they’ve been repossessed from a delinquent borrower and sold off to a buyer capable of making monthly payments. In other words, we’re in the bottom half of the first inning of this crisis.
Foreclosure is rarely the preferred solution. Borrowers lose their homes, of course. And for lenders it can be a relatively expensive solution. It’s generally cheaper for all concerned to make the mortgage payment manageable, either by allowing the borrower to do a short sale or lowering his payment to something he can afford.
But it matters how payments are lowered. Extend and pretend gimmicks — lowering rates, adding missed payments to the loan balance (“capitalization”), term extensions — are the most popular modifications as the table below from the latest Mortgage Metrics report demonstrates. However, these still leave borrowers with negative equity and a huge incentive to walk away. (Meanwhile principal forgiveness dropped dramatically from Q3 to Q4.*)
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But these adjustments don’t result in sustainable modifications, which is the whole point…
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Twelve months after modification, nearly 60% of modified borrowers are re-defaulting. Yes, more recent mods are performing better, but research shows that without forgiving principal, defaults will stay high.
Treasury’s new approach is a big step forward.
First, it will encourage lenders to write off principal, both investors who hold most first mortgages via mortgage-backed securities and banks that mostly hold second mortgages on their balance sheet.
First mortgages will be written down to 97.75% of the home’s current value, giving previously under water borrowers new skin in the game. These mortgages will be refinanced under FHA. On the one hand, that’s good since FHA loans verify income and are fully documented. On the other, that’s still not much equity and FHA mortgages have been defaulting at higher than average rates (compare the tables on pages 14 and 15 in the MM report).
At the same time, homes with second mortgages (about half of the 3-4 million targeted by Treasury’s program) would have to be written down so that total house debt (first mortgage + second) is no higher than 115% of the home’s value. Banks would be paid 10-20 cents for every dollar of principal they forgive on second mortgages, which means they eat the lion’s share of losses. Yeah, this still leaves these borrowers under water, but at least they’ll be much closer to the surface.
Another good feature: it won’t target all at-risk borrowers, just those who are current on their mortgage. This is important because the previous iteration of HAMP only allowed defaulted borrowers to qualify for government sponsored mods. Of course that gave them a big incentive to quit paying. Nor will the principal forgiveness come up front, it will be earned over a few years as long as borrowers stay current.
The biggest problems are that this will cost taxpayers an estimated $14 billion while using the public’s balance sheet to absorb even more mortgage debt. Is that a reasonable price to help arrest the foreclosure crisis? Depends on how big the indirect impact on taxpayers would be if it were allowed to spin out of control.
Theoretically, this program should get some traction since it benefits all concerned.
- Investors/banks holding first mortgages are big winners. While working on my second mortgages column, I spoke with a spokesman for the Mortgage Investors Coalition, which says it represents investors holding $100 billion worth of MBS. The plan announced on Friday is precisely what his group was pushing.
- Of course it’s good for borrowers.They get debt forgiveness.
- And even banks should buy into it since many of their second mortgages are worth very little.** This plan at least gives banks something.
That said, it could be very difficult to coordinate all the parties in question in order to get these modifications done. That’s the key risk according to Dobson: execution.
He notes that if these carrots don’t get lenders moving, regulators have a stick at their disposal. They could simply force banks to hold capital against the portion of mortgage debt no longer backed by a property’s value. This would effectively make them recognize losses up front.
They should probably do that anyway. Though banks have raised lots of equity capital over the past year, it’s probably not enough considering the losses still embedded on their balance sheets.
*Why did principal reductions suddenly fall in Q4? This is just a hunch, but I bet it had something to do with Wells Fargo. They have a huge pile of option ARMs via their acquisition of Wachovia. Because these were marked down when they were purchased, it costs Wells nothing to write off principal. They made a push to do that in Q3 I believe, which may have slowed down in Q4.
Option ARMs are the deepest under water mortgages, by the way, and the most common recipients of principal forgiveness according to the MM report.
**Loan balances are paid back when houses are sold or refinanced at prices above the value of the debt. If the debt exceeds the value of the home, however, the borrower has to stump up the cash. That’s exceedingly rare, so the second mortgage may get written off while the first takes a haircut. In practice, second mortgages may still be worth something. Since they are recourse loans, they can be sold to investors for cents on the dollar. In any case, they’re not worth what banks say they’re worth.