Thursday, March 5, 2009

The Treasury Mortgage Mod Program: Should We Hope It Doesn't Work?

By Yves Smith (Naked Capitalism):

The Treasury today announced its so-called "Making Homes Affordable Program".

I am clearly an old fart. The fact that the Treasury bothered to have a logo created for the program (do consumers and servicers really need brand imaging when having money shoved at them?) gives me more than a little pause. I will nevertheless try to keep my prejudices in check.

The program has two elements. The first is a refinancing program which targets 4 to 5 million borrowers. If you are in a Freddie or Fannie mortgage executed before Jan 1, 2009, which you occupy and is your primary residence, congrats, you can refi at today's low rates with less than the usual required 20% equity.

This post will focus on the second piece, the mortgage mod program intended to help 3 to 4 million borrowers. Recall that the Bushies had several goes at this problem, none very successful, but none of them looked like a serious effort either.

And before we poke and prod this program, remember, in general we are fans of mortgage mods. With lenders facing losses of 30% in normal times, and more like 40-50% given the severity of price declines and longer than usual clearing times on real estate inventory, there should be a fair number of opportunities where the lender could offer a deep principal reduction (20-30%). That would add up to a big enough payment reduction to salvage some borrowers, and still leave the lender better off than if he foreclosed. And this belief has some empirical support. Wilbur Ross, vulture investor (ie, not predisposed to be a friend of the little guy) is an advocate of deep principal reductions based on his success with them as the owner of the biggest third-party mortgage servicer.

Now of course, there is a very big complication with this "gee, there is a win-win space here, so why is no one making mods?" view. The big one is the difference in treatment of a mod (well, at least the principal reduction kind) versus a foreclosure. For a foreclosure, the losses go against the lowest tranches first, and then proceed to higher tranches. However, with a principal reduction, all tranches, including the AAA (or more accurately, what was once AAA) layer.

In many cases, the bank that is running the servicer holds some of that paper and would have to mark it down. Moreover, if mods like this were to become popular, former AAA paper would have to be written down even further. Quelle horreur!

But something sensible, likely to work, but possibly damaging to the fragile banking establishment is to be avoided at all costs (Larry Summers apparently does not subscribe to the widely held economic precept that the highest and best use of a market is to set clearing prices, and in this case, letting prices drop to clearing levels is necessary and ultimately unavoidable. The goal of policy should be to prevent an overshoot on the downside, not to impede the correction).

I have read the Treasury mortgage mod program, and it's a bit fuzzy on certain details, but there was enough that was troubling without being clear on all the program wrinkles.

First, it appears the program is a five year payment reduction program. While the guidelines are silent here, reasonable people would infer that the payment relief will be added to principal (particularly since the monthly borrower incentive for keeping current, is paid the servicer on behalf of the borrower to reduce principal, which suggests it is to offset principal increases). From the guidelines:
The Home Affordable Modification program has a simple goal: reduce the amount homeowners owe per month to sustainable levels to stabilize communities.

Yves here. I think they mean "pay" when they say "owe".

The program keeps the previously announced construct of having the lender reduce mortgage payments so they are no more than 38% of income, then Uncle Sam kicks in and provides a subsidy to bring the level down to 31%. Now we get to the doozy:
To ensure long-term affordability, the modified payments will be kept in place for five years and the loan rate will be capped for the life of the loan. After five years, the interest rate can be gradually stepped-up by 1% per year to the conforming loan survey rate in place at the time of the modification.

So effectively, the borrower gets a teaser that over time adjusts to a fixed rate mortgage at current (low) interest rates.

Let's think this through a second. The borrower is still under water (of course, Bernanke & Co. regard this as temporary misvaluation resulting from irrational pessimism, but the more data driven crowd sees housing prices as having moves way out of line with incomes. And the outlook for incomes isn't exactly rosy either). The borrower therefore has no reason to invest in the house, including routine maintenance (assuming he can somehow scare up the dough). If the boiler goes, the roof leaks, he has no incentive to fix it. Similarly, if he were to sell the house (let's say he got a good job elsewhere), he's still faced with either negotiating a short sale or walking and leaving the bank with the property. Thus for the bank all this does is kick the can down the road, unless we assume a recovery from these levels.

Ah, but we have our good friend inflation! The Fed is desperately trying to create inflation, surely that will take hold, raising nominal prices and lifting some borrowers out of negative equity status.

Yes, but we gave those borrowers teasers into fixed, Now the banks have low yielding (maybe negative yielding) assets. But the banks could hedge, correct? Yes, but mortgage hedging is nastily pro cyclical. The Fed was actually relieved when Freddie and Fannie had their balance sheet growth restrained in the aftermath of 2003 accounting scandals because their mortgage hedging is procyclical, and on such a scale that it was systemically destabilizing. So if this program works on the scale hoped for, we all can look forward to big time mortgage hedging whipsawing markets.

And the fine print has another doozy of a provision:
To encourage the modification of more mortgages and enable more families to keep their homes, the Administration -- together with the FDIC -- has developed an innovative payment that provides compensation that can partially offset losses from failed modification when home prices decline, but is structured as a simple cash payment on every eligible loan. The Treasury Department will make payments totaling up to $10 billion to discourage lenders, servicers and investors from opting to foreclose on mortgages that could be viable now out of fear that home prices will fall even further later on. This initiative provides servicers with the security to undertake more mortgage modifications by assuring that if home price declines continue to occur or worsen, investor losses are partially offset. Holders of mortgages modified under the program would be provided with an additional payment on each modified loan, linked to declines in the home price index.


In other words, if the program succeeds, we may not be so happy with where we wind up in a few years.

But I have my doubts that it will work. First, despite the bribes to servicers, I don't see strong reasons for them to play ball. These mods will be costly, I am not certain the comp is adequate, and mortgage securities holders may sue.

Second, the redefault rate on mortgage mods that do not have significant principal reduction in the first six months now is high. The New York Times reports that payment reductions are expected to be "hundreds of dollars" a month. Is that really going to make a difference with most borrowers, particularly since the interest portion is tax deductible and these mortgages are recent (ie, the interest component is a high proportion of the total payment).

Third, the program qualifies people based on mortgage payments relative to total income. Some consumers are so up to their eyeballs in debt that a mortgage mod is merely rearranging the deck chairs on the Titanic. So in this version of the program, borrowers with high levels of overall debt (55%= to income) get debt counseling! Let me tell you, someone in that fix is probably beyond hope. In the old days of easier credit, someone paying 29% on credit cards could get a somewhat less punitive rate via debt consolidation. I doubt there is much of that sort of credit on offer right now.

Fourth, second mortgage holders don't have reason to play ball. From the guidelines:
While eligible loan modifications will not require any participation by second lien holders, the program will include additional incentives to extinguish second liens on loans modified under the program, in order to reduce the overall indebtedness of the borrower and improve loan performance. Servicers will be eligible to receive compensation when they contact second lien holders and extinguish valid junior liens (according to a schedule to be specified by the Treasury Department, depending in part on combined loan to value). Servicers will be reimbursed for the release according to the specified schedule, and will also receive an extra $250 for obtaining a release of a valid second lien.

Fifth, these mods are voluntary. There is enough pressure being applied to banks now on government life support that they will be expected to make a good show of it, but the government has designed the template, and it is not obvious how much latitude banks have in participant selection (and whether they have the skills to make informed choices even if they were motivated to). However, there is limited protection against "mods for the sake of mods". The servicer gets no incentive payment if the borrower defaults within three months.

The possible real effect of the program may be revealed here:
Servicers will receive incentives to take alternatives to foreclosures, like short sales or taking of deeds in lieu of foreclosure. For those borrowers unable to maintain homeownership, even under the affordable terms offered, the plan will provide incentives to encourage families and servicers to avoid the costly foreclosure process and minimize the damage that foreclosure imposes on financial institutions, borrowers and communities alike. Servicers will be eligible for a payment of $500 and can make reimbursable payments up to $1000 to extinguish other liens, and borrowers are eligible for a payment of $1500 in relocation expenses in order to effectuate short sales and deeds-in-lieu of foreclosure.

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