The Obama administration last week announced several new initiatives to bring relief to homeowners struggling to pay their mortgages. But the big news behind the headlines is that the administration now boasts the first systematic set of policies to address the problem of “negative equity” (homeowners owing more than their homes are worth) by bringing the amount owned on mortgages down to the current value of the properties.
When borrowers face job losses, illness, death, or divorce, delinquency often results. But as long as borrowers have some equity in their home or are not too far under water, they will often do everything in their power to keep their homes. When these common default factors are coupled with significant negative equity, however, the decision to simply walk away from the home (and its mortgage) becomes much easier.
The decision to walk away, leaving the home vacant and abandoned, harms the value of neighboring properties, hurting people who may still be struggling to keep up with their own mortgages. That’s a major problem for communities across the country when an estimated 24 percent of all houses with mortgages are worth less than the remaining balance on those mortgages. Writing down the amount of outstanding mortgages to bring them in line with the current values of the properties provides an opportunity to create the conditions for homeowners to keep paying their mortgages over the long term and minimize the walkaway risk that threatens their neighbors’ financial health.
Since the housing crisis began, CAP has argued that the best solution is to restructure mortgages to reflect current property values. Drawing on the experience of history, the new initiative announced by the Obama administration involving the Federal Housing Authority and the $700 billion Troubled Asset Relief Program fits the bill. Indeed, the new program is essentially a modern version of the New Deal’s Home Owners’ Loan Corporation, which helped homeowners in the 1930s weather the Great Depression.
Under the Obama administration’s program, borrowers who are current on their loans but owe more on their homes than they are currently worth can refinance into an FHA loan for 97.75 percent of the property’s current value, assuming the borrowers meet all other FHA underwriting criteria. Incentives will be paid to the mortgage service companies handling the flow or mortgage principal and interest payments to lenders and investors in these mortgages so that borrowers can refinance for less than the outstanding amount.
Given the much larger losses lenders and investors would face if borrowers defaulted, cash in hand equal to 97.75 percent of current value may be sufficiently attractive to allow these refinancings to proceed. This is actually a somewhat sweeter deal for lenders and investors than was offered by FDR’s administration by the Home Owners Loan Corporation; back then, the new mortgage was for only 80 percent of current value and the lenders were given corporate bonds paying 4 percent in the amount of the new HOLC loan, not a cash buyout.
Moreover, the Obama administration’s FHA program will allow a total indebtedness of 115 percent of the home’s current value, so existing lenders and investors will still be able to retain almost a fifth of the property’s current value as a junior lien on the property, effectively giving them some ongoing cash flow if the loan performs and some upside if property values rise before foreclosure. In cases where there is an existing second lien on the home (in the form mostly of a home equity loan) then the first- and second-lien holders would need to negotiate how to divide losses down to the 115 percent loan-to-value limit.
About half of all homes have second liens on the property. Given the difficulties faced by the administration’s first effort to help responsible homeowners refinance their mortgages through its Making Home Affordable program because of second liens, this program will be most useful for borrowers with only a first mortgage.
To finance this new program, $14 billion from the Troubled Asset Relief Program will be set aside. Even though these refinancings will be FHA loans in all respects and must qualify on those terms, TARP will be on the hook for future claims in a first-loss position. The new program also will bolster FHA’s insurance fund, whose excess reserves are below their statutory minimum, since premiums will be paid into the fund but claims will first be drawn down from TARP.
For HAMP-eligible borrowers—meaning those borrowers already determined to be eligible for mortgage refinancings—the so-called Net Present Value test will now be run a second time to calculate the value of a modification that includes a principal writedown. Under the existing HAMP NPV test, the monthly payment target of 31 percent of a borrower’s income is reached by reducing the interest rate to as low as 2 percent, extending the length of the loan to as much as 40 years, or forbearing part of the loan so that no interest is due on that amount.
To qualify for the new program, the results of the two NPV tests will be compared so that mortgage service companies will see the logic of participating in the program. The mortgage service companies will be under no programmatic obligation within HAMP to modify mortgages using a principal writedown even when the NPV results show it to be more valuable, yet servicers’ existing legal obligations to lenders and investors to get the best possible returns from modifications would make it difficult for servicers to choose the standard HAMP modification when the principal writedown alternative yields better returns under the same NPV model.
Furthermore, in most instances, principal writedowns will probably be more valuable compared to the current HAMP modifications, because of the reduced redefault risk from a lower loan-to-value ratio. Why? Because the amount forgiven will be deducted from the loan balance over the course of the next three years, as long as the borrower remains current on their loan.
This policy’s ultimate success, however, will likely be determined by the success of the administration’s so-called 2MP program, which is designed to buy out second-lien holders for pennies on the dollar but has yet to get off the ground. The four largest banks, which collectively hold about 80 percent of all second liens, are also the four largest mortgage servicers. Only very recently did all four agree to participate in the 2MP program. And under the new administration program to encourage the elimination of second liens prior to the principal writedowns, which will necessarily generate losses for first-lien holders, the incentive payments to the second-lien holders under 2MP will be doubled. If 2MP proves ineffective at eliminating second liens, however, it is unlikely that first liens will be written down.
But there is reason for optimism. Commercial banks that still hold the mortgages they originated are now beginning to offer principal reductions for loans they originated and hold in their portfolios, recognizing the value in reducing the risk of redefault. Last week, for example, Bank of America announced its own program of principal reductions for borrowers with certain exotic mortgages. BofA’s new program is expected to reach only 45,000 borrowers, but the rationale behind principal reductions should argue for the program’s rapid expansion to their entire mortgage servicing portfolio.
Taken together with the administration’s initiatives, it is clear that a consensus is emerging that principal reductions are an important tool in preventing foreclosures, as CAP has advocated since 2007. To be sure, implementing these changes will be difficult, and the issue of second liens remains a challenge. But insofar as the FHA refinancing program can largely sidestep the issue of mortgage servicer capacity (as we have argued elsewhere as a way to increase the rate of modifications), it has significant potential to alleviate the foreclosure crisis.
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