«Barriers to Federal Home Mortgage Modification Efforts During the Financial Crisis Patricia A. McCoy August 2010 MF10-6 Paper originally presented at ...»
Joint Center for Housing Studies
Barriers to Federal Home Mortgage Modification Efforts
During the Financial Crisis
Patricia A. McCoy
Paper originally presented at Moving Forward: The Future of Consumer Credit and Mortgage Finance – A National
Symposium held on February 18 and 19, 2010 at Harvard Business School in Boston, Massachusetts.
© by Patricia A. McCoy. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.
Any opinions expressed are those of the author and not those of the Joint Center for Housing Studies of Harvard University or of any of the persons or organizations providing support to the Joint Center for Housing Studies.
Introduction Since mid-2007, the federal government has devoted enormous sums of money and effort to foreclosure prevention. Washington’s approach to rising foreclosures has evolved over time. In the first iteration, the government confined its efforts to coordinating loss mitigation by private industry. In the second iteration, starting with President Obama, the government supplemented that approach with subsidies for loan modifications. To a lesser degree, the Obama Administration has also attempted to increase the costs to servicers of rushing to foreclosure.
So far, the results have been mixed. Under the George W. Bush Administration, two successive programs to refinance distressed borrowers into FHA loans turned out to be a failure.
Last December, the Obama Administration’s ambitious program to increase loan modifications stumbled when the government revealed that most temporary modifications failed to graduate to permanent modifications. While the graduation rate has since improved, the level of permanent modifications remains well below what policymakers had hoped for.
To bring permanent modifications to scale, more will be needed. The lack of permanent modifications may partly be due to insufficient subsidies to servicers for underwriting permanent modifications. More importantly, the resistance to permanent modifications may also be the product of accounting rules that require immediate write-downs for reductions in interest rates or principal that are permanent in nature, rather than temporary.
If the latter is the case, then stronger medicine will be needed. Short of overhauling the accounting rules – which raises larger complications of its own – the government’s options are limited. Either it will have to further subsidize losses arising from write-downs, compel write- downs by law, or encourage voluntary write-downs through stronger means, including the threat of bankruptcy cram-downs or slower access to foreclosure court.
Rationales for Foreclosure Mitigation During the financial crisis, policymakers advanced two main justifications for foreclosure prevention. The first consisted of the economic self-interest of investors, while the second involved minimizing the harmful spillover effects to society from foreclosures.
Interestingly, redressing wrongs to injured borrowers was not a central rationale for loss mitigation. From an operational perspective, resolving wrongs to select borrowers would likely mire the loss mitigation process in protracted delays. Public backlash by some against borrowers
Potential Benefits to Investors and Other Holders In numerous instances, holders of distressed home mortgages could reduce their losses by agreeing to workouts instead of going to foreclosure. This dynamic is especially compelling for non-conforming mortgages, i.e., loans not guaranteed by Fannie Mae, Freddie Mac, or the federal government. Jumbo mortgages and most subprime mortgages are non-conforming loans.
Most of these were securitized in the private-label residential mortgage-backed securities (RMBS) market.
The loss severity rates from subprime residential foreclosures average around 50%.2 This high loss severity results largely from the high deadweight costs surrounding foreclosure. The biggest deadweight costs are missed mortgage payments during the period leading up to foreclosure.3 In addition, the lender or trust incurs assorted transaction costs during the process of foreclosure, including realtor commissions, legal fees, utilities, taxes, insurance, and maintenance. These costs can consume 10% to 15% of the loan balance. Finally, foreclosed homes sell at a 5% to 15% discount compared to normal homes, due to the fire sale nature of foreclosure and the poor condition of many foreclosed homes.4 These high loss severities create room in many instances for investors and banks to cut their losses by agreeing to workouts of troubled loans.
Avoiding Harmful Spillover Effects Avoiding harmful spillover effects to society from foreclosures was the other major impetus for loss mitigation programs. This objective gained added urgency as falling housing prices dragged down the larger economy.
1 Kiff and Klyuev (2009), at 14.
2 Cordell et al. (2008), at 12-13. See also Bernanke (2008), at 3.
3 Generally, servicers are contractually obliged to advance principal and interest to the trust pending foreclosure. Once a foreclosure proceeds to sale, however, servicers can recoup those advances from the sale proceeds. Cordell et al. (2008), at 11.
4 Bernanke (2008), at 3; Cordell et al. (2008), at 11-13.
2 Starting in 2007, the national decline in home prices created a negative feedback effect that triggered and then prolonged the ensuing recession.5 As home prices dropped, more and more homeowners fell into negative equity when the balances on their mortgages came to exceed the value of their homes. Previously, during the housing boom, many of these households had taken out subprime or exotic adjustable-rate mortgages (ARMs)6 with payments that ultimately became unmanageable. Once their home equity evaporated, these “underwater” borrowers found that they could not refinance or sell their homes for enough to retire their loans. The result was a sharp spike in residential mortgage delinquencies and foreclosures.
Mounting foreclosures further depressed housing prices. On the demand side, foreclosures fueled tighter credit as banks raised their underwriting standards to prevent more delinquencies. Losses from foreclosures also eroded banks’ capital, constraining their capacity to lend. The resulting dearth of credit dampened the number of buyers looking for homes.
Foreclosures also had supply side effects. As foreclosure sales flooded the market, foreclosed homes sold at steep discounts, further pushing down home prices. Foreclosed properties depress the values of nearby homes by anywhere from 1% to 9%.7 That, in turn, reduces the property tax revenues on those neighboring homes. Vacant foreclosed homes also breed squatters, vandalism, and crime, sending neighborhoods into a tailspin and requiring higher municipal outlays for police and social services.8 Eventually, the downward spiral in property values pulled down the larger economy. As households became unable to tap their home equity to spend, purchases declined. Consumption fell and employers laid off workers (Figure 1), causing household incomes to contract.
Shrinking paychecks forced more and more households to default on their mortgages. (Figure 2).
By the end of 2009, serious delinquencies had hit an all-time high. In December 2009, 7.01% of all prime mortgages were 90 days delinquent or more, compared to 3.74% in December 2008.
Over that same period, the percentage of subprime mortgages that were 90 days delinquent or more soared from 23.11% to 30.56%.9 Meanwhile, foreclosure inventories rose to record highs 5 Kiff and Klyuev (2009), at 4-5.
6 Most notably hybrid 2/28 or 3/27 ARMs, interest-only ARMs, and option payment ARMs.
7 Kiff and Klyuev (2009), at 5.
8 Bernanke (2008), at 3; Kiff and Klyuev (2009), at 13.
9 Mortgage Bankers of America (2010).
Federal Foreclosure Prevention Policies The federal government has three basic models for foreclosure prevention at its disposal.
First, it can convene market actors to coordinate and facilitate foreclosure prevention by private industry. Second, the government can offer subsidies to induce foreclosure prevention. Finally, the government can take actions to increase the costs to market participants of pursuing unnecessary foreclosures.
During the current economic crisis, the federal government mainly pursued the first and second models. The third model had sparing use. At any given point during the crisis, the model that was chosen depended on the objective being pursued – refinancing or loan modification – and the Administration that was in power.
Refinance Programs for Delinquent Borrowers During the summer of 2007, the private-label market for RMBS crashed, setting the stage for a tsunami of foreclosures. Once the private-label market vanished, many financially stressed borrowers were no longer able to refinance unaffordable loans. The paucity of refinance options was especially severe for borrowers who were delinquent or had underwater loans (meaning loans in excess of the value of their homes). With no way to escape impending rate resets on their ARMs and other onerous loan terms, millions of households were soon in default.
That summer, the federal government sought to stave off the wave of foreclosures by refinancing some delinquent borrowers into FHA-insured loans. The first major refinance program was FHASecure, which the George W. Bush Administration launched in August 2007.
Under FHASecure, borrowers who faced high payment shock from imminent rate resets on their adjustable-rate loans were given the opportunity to refinance into FHA-insured fixed-rate loans.
Participation by servicers was voluntary. Servicers shunned the program, however, because it
10 Standard & Poor’s (2010).
4 required them to take a write-down of 3% or 10%, depending on the borrowers’ circumstances, for the borrower to qualify for an FHASecure loan. Eventually, after only about 4,100 borrowers qualified for the loans, the federal government brought the program to a halt at the end of 2008.11 In October 2008, the Bush Administration rolled out another refinance program, called Home for Homeowners or H4H. H4H was designed to refinance delinquent borrowers with underwater loans into FHA-insured mortgages. Again, under H4H, servicers had to first write down the principal, this time to no more than 96.5% (or sometimes 90%) of appraised value. In addition, servicers had to pay a 3% upfront FHA insurance premium and waive prepayment penalties and late fees. Borrowers had to share any future property appreciation at resale with the government. Like FHASecure, these terms were no more attractive to servicers than going to foreclosure. The program was an abysmal failure: by May 2009, only one borrower had been refinanced into an H4H loan.12 These refinance programs were the main instance in which the Bush Administration offered subsidies to promote foreclosure prevention. Nevertheless, both programs had a dismal rate of success because they depended on cooperation by servicers on unattractive terms. In designing both programs, the government tried to navigate competing goals without success.
Thus, the government imposed the write-down requirements to avoid rewarding lenders for making inflated amounts of loans. But with participation voluntary, servicers were unwilling to take large, certain write-downs instead of taking their chances on foreclosure. Furthermore, in H4H, the government made servicers, not borrowers, pay the FHA insurance premium on the assumption (usually correct) that distressed borrowers lacked that kind of cash. This hefty premium, along with the mandatory waiver of prepayment penalties and late fees, were an added reason why H4H refinancings did not appeal to servicers.
Loan Workouts Federal programs to encourage loan workouts were the other major approach to foreclosure mitigation during the crisis. Under the George W. Bush Administration, the federal government mostly relied on the first model – coordinating private industry efforts -- to prod
11 Corkery (2008).12 Kiff and Klyuev (2009), at 21-22; Merle (2009).
5 servicers to modify distressed loans, to little avail. In contrast, the Obama Administration adopted the second model, offering subsidies to servicers to modify distressed loans.13 During the early stages of the crisis, in 2007 and the first part of 2008, public policy was mostly concerned with impending rate resets on ARMs. As the crisis progressed, however, the spike in early payment defaults made clear that increasing numbers of homeowners could not afford their monthly mortgage payments even at the initial interest rates. Some of these loans were infected with fraud or sloppily underwritten from the start, especially reduced documentation loans. The widening recession also took its toll. Between May 2007 and November 2009, unemployment soared from 4.4% to 10%.14 Others who remained employed suffered lower wages due to reduced hours or pay cuts. By 2009, lost income outstripped other reasons for seeking loan workouts, such as rate resets or illness.15 As this evidence amassed, it became increasingly clear that lower monthly payments were essential to successful loan workouts.16 When loans become delinquent or in danger of default, servicers have a variety of workout techniques at their disposal to resolve those loans short of foreclosure. (I use “loan workout” broadly in this paper to refer to the full spectrum of techniques to resolve distressed loans other than foreclosure). Some workout techniques lower monthly payments, while others do not. Capitalization takes the borrower’s arrears and tacks them onto the principal, thereby increasing the monthly payments.17 Capitalization does not involve modification of any loan terms. Loan modifications, in contrast, alter the loan terms, either by extending the term of the loan, reducing the interest rate, lowering the principal, or some combination of the three. Many loan modifications have the effect of lowering monthly payments.