Monday, November 16, 2009

Capital in the Hamp-er

Posted on FT Alphaville by Tracy Alloway:

For some reason we find the Home Affordable Modification Plan — the US government’s programme to encourage lenders and mortgage servicers to reduce interest payments for certain homeowners — and its impact on banks fascinating.

And so, we read with interest the following press release from last Friday:

Agencies Issue Final Rule for Mortgage Loans Modified Under the Home Affordable Mortgage Program

The federal bank and thrift regulatory agencies today issued a final rule providing that mortgage loans modified under the U.S. Department of the Treasury’s Home Affordable Mortgage Program (HAMP) will generally retain the risk weight appropriate to the mortgage loan prior to modification.

The agencies adopted as final their interim final rule issued on June 30, 2009, with one modification. The final rule clarifies that mortgage loans whose HAMP modifications are in the trial period, and not yet permanent, qualify for the risk-based capital treatment contained in the rule.

The final rule, issued by the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of Thrift Supervision, will take effect 30 days after publication in the Federal Register, which is expected shortly.

Bear with us here, because this is a bit confusing.

Under the agencies’ current rules, it looks like mortgage loans are generally given either a 50 per cent or a 100 per cent capital risk weighting depending on things like whether they’re fully secured by first liens or meet “certain prudential critieria”. Under OCC rules, to receive the 50 per cent ranking a mortgage loan must “not [be] on nonaccrual or restructured” status. And under the Board’s general risk-based capital rules for bank holding companies and state member banks, mortgage loans must be “performing in accordance with their original terms” and not carried in nonaccrual status, in order to receive a 50 per cent risk weight.

All of which means, that mortgage loans modified under the Hamp programme might have generally been considered to have been restructured (OCC) or not considered to be performing in accordance with their original terms (Board). Thus they would have had to be risk-weighted at 100 per cent. That would have been bad news for banks — and bad news for the Hamp, since it could have disincentivised financial institutions from holding onto the mortgages.

What the above rule does then, is make sure banks aren’t discouraged from modifying or holding onto modified Hamp loans. There was already a hint of this coming since a similar interim rule was published in June, 2009. This is the final version of the rule.

What’s interesting then are the differences between the interim rule and this final rule, and how the banks tried (as they are wont) to game the regulatory capital system. Here’s a bit of detail from the full rule document:

The agencies received six comments on the interim rule, one from a banking organization, four from trade groups representing the financial industry, and one from an individual. The commenters that addressed the interim final rule unanimously supported it, asserting that it is consistent with the important policy objectives of the Program and does not compromise the goals of safety and soundness. Commenters requested that the agencies clarify whether the rule’s capital treatment is available for a mortgage loan that has been modified on a preliminary basis under the Program, but which still is within the trial period (and, thus, has not been permanently modified). Commenters also requested clarification regarding the circumstances under which a mortgage loan that was risk-weighted at 100 percent immediately prior to modification under the Program could receive a 50 percent risk weight. Some commenters suggested that such a loan should receive a 50 percent risk weight following completion of the trial period or following receipt of the first pay-for-performance incentive payments. Other commenters requested that the agencies clarify that a sustained period of repayment performance could include payments made after a loan had been modified under the Program.

Remember that one of the big controversies related to the Hamp programme is that while about 650,000 three-month trial modifications have been initiated, very few permanent mods have been made. Whether the rule would apply to trial mods would thus have had a very big impact on the banks.

This is what’s been decided (or clarified) on the trial/permanent point:

Based on the analysis of the comments, the agencies have modified the rule to specify that a mortgage modified on a permanent or trial basis pursuant to the Program and that was risk-weighted at 50 percent may continue to receive a 50 percent risk weighted provided it meets its other prudential criteria.19

[Footnote] 19 The agencies intended the interim rule to apply to loans modified on both a trial and permanent basis under the Program. Accordingly, the modifications to the final rule are clarifying in nature.

And on the “sustained” payment bit:

As noted in the preamble to the interim rule, under the agencies’ existing practice, past due and nonaccrual loans that receive a 100 percent risk weight may return to a 50 percent risk weight under certain circumstances, including after demonstration of a sustained period of repayment performance. Because borrower characteristics, such as debt service capacity, impact a borrower’s creditworthiness, the degree of appropriate reliance on a fixed period of payment performance may vary for different borrowers. For these reasons, the agencies have not established a specific period of repayments that would constitute a “sustained period of performance” for a particular loan. The agencies confirm that a borrower’s payments on a mortgage loan modified under the Program, including during the trial period, may be considered in assessing whether the borrower has demonstrated a sustained period of repayment performance.

Which seems to mean that past due and nonaccrual loans with a 100 per cent risk weight can return to 50 per cent, if the borrower demonstrates they can make the new payment over a “sustained period of time” — but there’s no specific timeframe for that period.

If you’re falling asleep at this point (as you probably should be) just remember the above as another example of how the whole of the US financial regulatory system now looks geared towards making these sort of loan modifications palatable for the parties involved.

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