The Federal Deposit Insurance Corp. and the Treasury Department need to ensure that the new Public-Private Investment Program to clean banks of toxic assets does not upend the Obama administration’s existing efforts to resolve the housing crisis. Specifically, the administration’s new mortgage modification program could be undercut by PPIP’s so called Legacy Loans Program, which will allow banks to sell their existing mortgages to new owners with no obligation to participate in the existing modification program.
Allowing this to happen would undercut the most promising effort to date to resolve the housing crisis—the root cause of today’s continuing financial market jitters and the main reason our economy fell into recession under President Bush beginning in December 2007. Fortunately, though, the FDIC and Treasury can resolve this problem relatively easily.
By requiring private investors in the Legacy Loan Program to participate in the home mortgage modification program, homeowners will get relief regardless of who owns their loan and the new owners of these mortgages, which includes the taxpayers who are putting up half the equity in these deals. What’s more, participating in the mortgage modification program will maximize their profits. That’s the simple explanation. Now for the details to underscore why this fix is needed and how it would work.
The Legacy Loan Program is designed to get existing toxic whole mortgages retained by banks off of their balance sheets. The LLP involves four parties:
- The banks selling mortgages.
- The private investors buying the mortgages.
- The United States Treasury, which will put up half the equity for the purchase.
- The FDIC, which will provide leverage to the buyers and run the auctions.
Under the LLP, banks will assemble pools of loans they wish to sell at auction. The private buyers will partner with Treasury to create Public-Private Investment Funds to buy the pools at an FDIC-run auction. The FDIC will examine the pools to determine how much leverage they would be willing to offer the buyers, up to a six-to-one debt-to-equity ratio. Thus, on a hypothetical pool of mortgages bought for $14, a Private-Public Investment Fund would put in $2 in equity and the FDIC would lend $12 in exchange for a small fee and a second-loss position—meaning investors and Treasury would get wiped out before the FDIC would have to pay out any claims. Of the $2 in equity, half would come from the private sector and half would come from Treasury.
The Emergency Economic Stabilization Act of 2008, which established TARP, shows a clear congressional intent that it expected Treasury to acquire mortgages for the purpose of modifying them to keep families from foreclosure. To that end, Section 109 of the bill requires the Secretary of the Treasury, upon acquiring mortgages, to establish a modification program—such as HAMP—and to encourage servicers to modify mortgages. Because Treasury is buying an interest in mortgages as an equity partner in every Public-Private Investment Fund, this obligation should attach, and program rules and contracts should be drawn up so as to leave no ambiguity in the implementation of congressional intent to modify mortgages and avoid unnecessary foreclosures.
The loans eligible—or likely to become eligible—for modification under HAMP are among those most likely to be sold by banks under the LLP. Note that accounting rules do not require banks to write down the value of performing mortgages tied to homes whose values have dropped; banks are unlikely to offer these still current but under water mortgages for sale as investors will likely be willing only to pay based on the current value of the property not the face value of the note. Delinquent loans which are the domain of HAMP, however, must be—by the strictures of accounting rules, written down on banks’ books—inflicting harm to bank balance sheets that they can ill-afford. HAMP offers banks incentives for modifying loans, creating loans that are of greater quality after modification. But the shaky banks are likely to decide that they are better off selling the loans to completely move the risk from their books.
Banks—or their servicing agents who contract to process the payments—who participate in HAMP must offer a standardized modification down to 31 percent of a borrower’s income in all cases where the value of modifying the mortgage is greater than the proceeds from foreclosing. To determine the value of the possible outcomes—modification or foreclosure—HAMP requires a net-present -value test that includes an adjustment for the risk of redefault, among other things. If banks, in practice, believe that certain loans will have higher redefault rates than the HAMP model assumes, then they will likely sell off the loans they would otherwise be forced to modify under HAMP.
Moreover, there is great concern about the servicing industry’s capacity to respond to the volume of requests for modifications and other assistance. Banks, knowing they will need to write down the value of their mortgages anyway, may simply choose to sell the mortgages rather than invest in the servicing infrastructure and staffing levels necessary to handle the modifications.
One of the LLP ground rules requires a third-party valuation company to examine the loans being offered for sale. While the purpose of this valuation is to determine the quality of the assets so that the FDIC can adjust its leverage ratio accordingly (riskier assets get lower leverage), this test should not be fundamentally different from the net-present-value test required under HAMP. As such, the system is essentially building the necessary capacity to analyze these mortgages as a precursor to offering modifications. The price paid at auction should approach the value of the mortgages after modification less the costs to modify and service the mortgages on an ongoing basis rather than the assumed residual value in the property after foreclosure.
Simply stated, if there is public subsidy being used for the acquisition of whole loans, then the buyers should be obligated to play by the rules of the modification program. This keeps things relatively straightforward and offers a consistent outcome for homeowners and mortgage holders. Since modification under HAMP should proceed where it maximizes value, the question for the banks becomes whether they want to retain the risk of redefault or not. If they do, they modify and hold the mortgages. If not, they sell through the LLP and the new owners make the modifications.
It has been suggested that too many strings on investors might keep them from participating and that maintaining the HAMP requirements in some form might be viewed in that light. The burden, however, will not generally be significant. The buyers of these loans are not likely to directly service these loans but hire a third party to do it, possibly even hiring the current owners to service them. As such, it does not present a significant burden for the buyers.
In addition, since modification under HAMP takes place only when the net present value of modification is greater than foreclosing, it creates net value for the buyer rather than imposing a cost. Leveling the playing field to create identical modification outcomes regardless of owner will also minimize banks’ incentives to simply swap out loans currently on their books and subject to HAMP for new loans that could be shielded from HAMP in a Public-Private Investment Fund.
Similarly, we would expect the Legacy Securities Program, the LLP’s companion program that will establish investment funds to buy mortgage-backed securities, to require the fund managers that will oversee the investments to, at the minimum, accept all requests for modifications under HAMP, and ideally reach out to the servicers to mandate their participation in the program.
From the beginning of the crisis, the Center for American Progress has consistently said that by helping homeowners at risk, we can help banks as well. Now that we have a program in place that will finally offer sustainable modifications in keeping with a commitment to maximize returns to the note holders (investors and lenders), it’s a shame that we are willing to put up public funds to transfer loans to third parties without this component. Whether the precise approach offered here is adopted or not, it’s is vital that a mechanism be found to ensure that PPIP does not undermine the efforts to spur loan modifications that is enshrined in HAMP.
Andrew Jakabovics is Associate Director for the Economic Mobility Program at the Center for American Progress. To read more about the Center’s solutions to the housing crisis please go to the Housing page on our website.