Financial Markets

Martin Eakes’ testimony before the US Senate Committee on Banking, Housing and Urban Affairs in Washington is worth reading. Read full testimony here.

Numerous legal and structural obstacles stand in the way of modifications.

A recent Federal Reserve Staff Working Paper identifies a number of obstacles that limit the scale of modifications.14 These obstacles help explain why voluntary loss mitigation cannot keep up with demand.

 � Investor Concerns: Servicers may shy away from modifications for fear of investor lawsuits.15 While most Pooling and Servicing Agreements (PSAs) provide adequate authority to modify loans, these modifications may cause disproportionate harm to certain tranches of securities over other classes. Investors are also particularly concerned about re-default risk, where their short term losses from modifications will be compounded by future foreclosure costs, which will increase as housing prices continue to fall, if the borrower cannot sustain payments under the modified terms. In addition, when servicing securitized loans, some PSAs do limit what servicers can do by way of modification. For example, some limit the number or percentage of loans in a pool that can be modified.16

 � Second Liens: Additional liens on a property pose a structural obstacle that is often impossible for servicers of the first lien to overcome. Between one-third and one-half of the homes purchased in 2006 with subprime mortgages have second mortgages,17 and many more homeowners have open home equity lines of credit secured by their home. The holder of the first mortgage will not generally want to provide modifications that would simply free up homeowner resources to make payments on a formerly worthless junior lien, nor to modify a loan where there is a second mortgage in default. But as Credit Suisse reports, “it is often difficult, if not impossible, to force a second-lien holder to take the pain prior to a first-lien holder when it comes to modifications,” thereby dooming the effort.18

� Servicer Incentives: The way servicers are compensated by lenders creates a bias for moving forward with foreclosure rather than engaging in foreclosure prevention. Servicers are often not paid for modifications, but are reimbursed for foreclosure costs.19 The Federal Reserve concludes, “Loan loss mitigation is labor intensive and thus raises servicing costs, which in turn make it more likely that a servicer would forego loss mitigation and pursue foreclosure even if the investor would be better off if foreclosure were avoided.”20

 � Limited Servicer Staff and Technology: With few but welcome recent exceptions, servicers have continued to process loan modifications in a labor-intensive, case-by-case review. While they have added staff and enhanced systems, the lack of transparent, standardized formulas has limited the number of modifications that have been produced.21

Later . . . 

 Since taking over IndyMac Bank, the FDIC has developed a streamlined and systematic approach to loan modifications for IndyMac’s loans. Similar approaches have now been adopted as part of a recent settlement between Bank of America and state Attorney Generals regarding unfair and deceptive lending practices by Countrywide, and most recently by JP Morgan Chase/Washington Mutual and Citigroup. While some aspects of these modification programs are potentially problematic,22 and while these programs may not be able to reach sufficient numbers of loans held in private label securities where investors withhold their consent, these systematic approaches are a step in the right direction and can serve as a general model for the rest of the industry, with affordability enhancements that can be leveraged through the TARP program.

To facilitate as many loan modifications as possible, Treasury should adopt different strategies for three different categories of loans:

 � Loans in Private Label Securities: Treasury should adopt FDIC’s proposed loan modification guarantee program and provide guarantees to modifications from servicers with streamlined affordable modification protocols based on the FDIC/IndyMac model under the authority provided by Section 109 of EESA.

 � Loans Held By Fannie Mae and Freddie Mac: As the conservator for the GSEs, the Federal Housing Finance Agency should direct them to facilitate modifications to the greatest extent possible. The recent November 11 announcement is a positive step for these loans.

 � Loans Held in Portfolio by Banks and Thrifts: Treasury should require banks and thrifts that participate in Treasury’s equity investment or asset purchase program to adopt these streamlined loan modification protocols. A. FDIC has proposed a loan modification guarantee program through TARP that would create an efficient subsidy for modifications of loans held in private-label securities.

 FDIC has pioneered a promising approach to streamlined modifications in its operations at IndyMac Bank, which it is applying to IndyMac loans held in portfolio and to those it services for private mortgage-backed securities investors, where possible. It has now proposed a Treasury program under TARP that could substantially expand this promising approach and effectively address the existing obstacles to modifications, particularly the obstacles posed by private securitization.

The FDIC/IndyMac model compares the net present value of modifying the loan to foreclosing and losing money reselling the house. As long the modification provides a greater return than foreclosing, the loan can be modified. All loans are converted to fixed rate loans at the Freddie Mac Survey interest rate at the time of the modification, which is currently 6.2 percent. The model establishes a clear affordability target: a 38 percent debt-to-income ratio (DTI) for total housing payments for the IndyMac first mortgage (including mortgage principal, interest, taxes and insurance).

To reach the affordability target based on the income information they have (subject to income verification before being finalized), the model uses a three-step approach:

 � Servicers first reduce interest rates for five years, potentially to as low as 3%, to meet the DTI target. Thereafter the rate rises by 1% per year until it reaches a market rate, which is defined as the Freddie Mac survey rate.

 � If this rate reduction is not enough to reach the target DTI, the servicer would increase the loan term to a maximum of 40 years from date of origination.

 � If the loan still isn’t affordable, then a portion of principal would be deferred until the loan becomes due or pays off early, with no interest accruing. Monthly payments would be calculated on the lower balance, which would make the loan more affordable. Deferral, rather than forgiveness of principal, means that investors have the possibility of collecting on the full balance if housing prices recover.

 FDIC has also introduced some important procedural changes to try to increase response rates. Where they have income information, they establish a pre-approved modification offer which they send to the borrower via certified mail. To accept, the borrower can return the offer in an enclosed pre-paid envelope, with a signature, a lower payment and current income verification documentation. Where FDIC does not have borrower income information, they have used mail, phone calls and payments to counselors to try to contact borrowers.

Although it is still in its early stages, the FDIC /IndyMac model appears to be increasing modifications substantially and reducing foreclosures on its existing portfolio. So far, there has been a 75 percent response rate where FDIC has income information about the borrower and approximately 5,000 loans have been modified.23 FDIC officials remain optimistic that this approach can also increase modifications for its securitized loans as well.

 

 

 

 

The FDIC/IndyMac model has already served as a model for other servicers as a way to expand and streamline loss mitigation efforts. Three other entities have adopted similar approaches: the Bank of America settlement of State Attorneys General lawsuits against Countrywide for unfair and deceptive lending practices, and more recently, voluntary efforts announced by JP Morgan Chase/Washington Mutual and by Citigroup. The Bank of America settlement establishes a lower affordability target of 34% of total housing debt to income.