Helping Distressed Borrowers
Policymakers and stakeholders have been working to find effective responses to the increases in delinquencies and foreclosures. Steps that have been taken include initiating programs designed to expand refinancing opportunities and efforts to facilitate and increase the pace of loan workouts. Troubled borrowers will always require individual attention, and the most immediate impacts of foreclosures are on local communities. Thus, the support of counselors, lenders, and organizations with local ties is critical.
Of course, care must be taken in designing solutions. Measures that lead to a sustainable outcome are to be preferred to temporary palliatives, which may only put off foreclosure and perhaps increase its ultimate costs. Solutions should also be prudent and consistent with the safety and soundness of the lender. Concerns about fairness and the need to minimize moral hazard add to the complexity of the issue; we want to help borrowers in trouble, but we do not want borrowers who have avoided problems through responsible financial management to feel that they are being unfairly penalized.
Let me turn now to some recent efforts to help distressed borrowers refinance. The FHASecure plan, which the Federal Housing Administration (FHA) announced late last summer, offers qualified borrowers who are delinquent because of an interest rate reset the opportunity to refinance into an FHA-insured mortgage. Recently, the Congress and Administration temporarily increased the maximum loan value eligible for FHA insurance, which should allow more borrowers, particularly those in communities with higher-priced homes, to qualify for this program and to be eligible for refinancing into FHA-insured loans more generally. These efforts represent a step in the right direction. Not all borrowers are eligible for this program, of course; in particular, some equity is needed to qualify. In addition, second-lien holders must settle or be willing to re-subordinate their claims for an FHA loan, which has sometimes proved difficult to negotiate. Separately, some states have created funds to offer refinancing options, but eligibility criteria tend to be tight and the take-up rates appear to be low thus far.
In cases where refinancing is not possible, the next-best solution may often be some type of loss-mitigation arrangement between the lender and the distressed borrower. Indeed, the Federal Reserve and other regulators have issued guidance urging lenders and servicers to pursue such arrangements as an alternative to foreclosure when feasible and prudent.5 For the lender or servicer, working out a loan makes economic sense if the net present value (NPV) of the payments under a loss-mitigation strategy exceeds the NPV of payments that would be received in foreclosure.6 Loss mitigation is made more attractive by the fact that foreclosure costs are often substantial. Historically, the foreclosure process has usually taken from a few months up to a year and a half, depending on state law and whether the borrower files for bankruptcy. The losses to the lender include the missed mortgage payments during that period, taxes, legal and administrative fees, real estate owned (REO) sales commissions, and maintenance expenses. Additional losses arise from the reduction in value associated with repossessed properties, particularly if they are unoccupied for some period.
A recent estimate based on subprime mortgages foreclosed in the fourth quarter of 2007 indicated that total losses exceeded 50 percent of the principal balance, with legal, sales, and maintenance expenses alone amounting to more than 10 percent of principal. With the time period between the last mortgage payment and REO liquidation lengthening in recent months, this loss rate will likely grow even larger. Moreover, as the time to liquidation increases, the uncertainty about the losses increases as well. The low prices offered for subprime-related securities in secondary markets support the impression that the potential for recovery through foreclosure is limited. The magnitude of, and uncertainty about, expected losses in a foreclosure suggest considerable scope for negotiating a mutually beneficial outcome if the borrower wants to stay in the home.
Unfortunately, even though workouts may often be the best economic alternative, mortgage securitization and the constraints faced by servicers may make such workouts less likely. For example, trusts vary in the type and scope of modifications that are explicitly permitted, and these differences raise operational compliance costs and litigation risks. Thus, servicers may not pursue workout options that are in the collective interests of investors and borrowers. Some progress has been made (for example, through clarification of accounting rules) in reducing the disincentive for servicers to undertake economically sensible workouts. However, the barriers to, and disincentives for, workouts by servicers remain serious problems that need to be part of current discussions about how to reduce preventable foreclosures.
We now have more information about the recent pace of loss-mitigation activity than we did just a few months ago, thanks to surveys of servicers by the Mortgage Bankers Association, the Conference of State Bank Supervisors, the Hope Now Alliance, and others. These surveys generally indicate that servicers substantially increased the number of loan workouts in the latter part of last year. The Hope Now Alliance estimates that workouts of subprime mortgages rose from around 250,000 in the third quarter of 2007 to 300,000 in the fourth quarter, while workouts of prime mortgages rose from 150,000 to 175,000 over the same period. The pace of workouts picked up a bit more in January.
Despite this progress, delinquency and default rates have risen quickly, and servicers report that they are struggling to keep up with the increased volumes. Of course, not all delinquent subprime loans can be successfully worked out; for example, borrowers who purchased homes as speculative investments may not be interested in retaining the home, and some borrowers may not be able to sustain even a reduced stream of payments. Nevertheless, scope remains to prevent unnecessary foreclosures.
Lenders and servicers historically have relied on repayment plans as their preferred loss-mitigation technique. Under these plans, borrowers typically repay the mortgage arrears over a few months in addition to making their regularly scheduled mortgage payments. These plans are most appropriate if the borrower has suffered a potentially reversible setback, such as a job loss or illness. However, anecdotal evidence suggests that even in the best-case scenarios, borrowers given repayment plans re-default at a high rate, especially when the arrears are large.
Loan modifications, which involve any permanent change to the terms of the mortgage contract, may be preferred when the borrower cannot cope with the higher payments associated with a repayment plan. In such cases, the monthly payment is reduced through a lower interest rate, an extension of the maturity of the loan, or a write-down of the principal balance. The proposal by the Hope Now Alliance to freeze interest rates at the introductory rate for five years is an example of a modification, in this case applied to a class of eligible borrowers.
To date, permanent modifications that have occurred have typically involved a reduction in the interest rate, while reductions of principal balance have been quite rare. The preference by servicers for interest rate reductions could reflect familiarity with that technique, based on past episodes when most borrowers' problems could be solved that way. But the current housing difficulties differ from those in the past, largely because of the pervasiveness of negative equity positions. With low or negative equity, as I have mentioned, a stressed borrower has less ability (because there is no home equity to tap) and less financial incentive to try to remain in the home. In this environment, principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.
Lenders tell us that they are reluctant to write down principal. They say that if they were to write down the principal and house prices were to fall further, they could feel pressured to write down principal again. Moreover, were house prices instead to rise subsequently, the lender would not share in the gains. In an environment of falling house prices, however, whether a reduction in the interest rate is preferable to a principal writedown is not immediately clear. Both types of modification involve a concession of payments, are susceptible to additional pressures to write down again, and result in the same payments to the lender if the mortgage pays to maturity. The fact that most mortgages terminate before maturity either by prepayment or default may favor an interest rate reduction. However, as I have noted, when the mortgage is "under water," a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure.
In my view, we could also reduce preventable foreclosures if investors acting in their own self interests were to permit servicers to write down the mortgage liabilities of borrowers by accepting a short payoff in appropriate circumstances. For example, servicers could accept a principal writedown by an amount at least sufficient to allow the borrower to refinance into a new loan from another source. A writedown that is sufficient to make borrowers eligible for a new loan would remove the downside risk to investors of additional writedowns or a re-default. This arrangement might include a feature that allows the original investors to share in any future appreciation, as recently suggested, for example, by the Office of Thrift Supervision. Servicers could also benefit from greater use of short payoffs, as this approach would simplify the calculation of expected losses and eliminate the future costs and risks of retaining the troubled mortgage in the pool.
A potentially important step to facilitate greater use of short payoffs is the modernization of the FHA, which I have supported. Going beyond the current proposals for modernization, permitting the FHA greater latitude to set underwriting standards and risk-based premiums for mortgage refinancing--in a way that does not increase the expected cost to the taxpayer--would allow the FHA to help more troubled borrowers. A concern about such an approach is that servicers might refinance only their riskiest borrowers into the FHA program. A combination of careful underwriting, the use of risk premiums, and other measures (for example, a provision that would allow the FHA to return a mortgage that quickly re-defaults to the servicer) could help mitigate that risk.
There are, no doubt, tax-related, accounting, and legal obstacles to expanding the use of principal writedowns. For example, investors in different tranches of mortgage-backed securities may not benefit equally, securitized trusts may not be permitted to acquire new equity warrants, and principal writedowns may require a different accounting treatment than interest rate reductions. But just as market participants, with the help of regulators, obtained greater clarity on the use of interest rate freezes through guidelines issued by the American Securitization Forum, industry and regulator efforts could also help clarify how this alternative type of workout might be effectively applied.