Wednesday, December 9, 2009

Principals, forgiveness and a reborn Hamp?

Tuesday provided a veritable bonanza of info for any one following the US Treasury’s increasingly curious forays into mortgage modification.

The US House Financial Services Committee met to discuss the government’s response to the mortgage foreclosure crisis, the centrepiece of which is now the Home Affordable Modification Plan, or the Hamp.


Hamp is aimed at reducing interest payments and delaying principal payments for eligible homeowners. To do this they have to apply and then agree to enter a three-month trial period, in which they need to make the lower payments and submit some additional documentation (stuff like proof of income). If that’s done successfully, the homeowner is granted a permanent mortgage modification - with lower monthly interest payments and longer principal forbearance.

Only, a major problem of the programme is the number of permanent mods (or lack thereof) being completed.

To give you an idea of the problems the programme is facing, below is nice chart from the Tuesday testimony of Molly Sheehan, senior vice president at JP Morgan Chase Finance:

You can see that for every 100 Hamp trial plans initiated through April to September 2009, only about 20 borrowers managed to complete all the required documentation and were eligible for the modification. Of those 20, according to Sheehan, 15 will probably get a Hamp mod with a payment reduction.

Actual numbers, as you can see from the table, are even lower. Out of 199,033 mods offered in the period, just 4,302 have become permanent and completed.

The figures are similar over at Bank of America, the country’s biggest mortgage servicer (CHK). In his testimony, Bank of America Home Loans credit loss mitigation strategies exec Jack Schakett said that of 65,000 homeowners who have made the three trial payments, 50,000 have not submitted the right documentation. Those 65,000 trial mods are due to end on December 31.

Take Two

There are a number of reasons for the lack of conversion — negative equity, documentation, unemployment, etc. — most of which have been discussed at length. But it’s interesting that a movement towards something else - Hamp Take Two, if you like - seems to be gathering momentum.

In particular, the notion of principal forgiveness — not just forbearance — seems to be gaining a lot of support. The Federal Deposit Insurance Corporation, which is responsbile for insuring US bank deposits, for instance, said earlier this week that it might ask lenders to cut principal on mortgages.

And, like the Hamp itself, principal forgiveness would have an impact on banks.

Laurie S. Goodman, senior managing director of Amherst Securities, explained some of the potential effects in her testinomy to the Committee. She thinks principal forgiveness is the way to go, but financial conflicts of interest currently keep mortgage servicers from reducing amounts owed. Servicer fees are often based on the principal amount, for instance, and the servicers themselves are often owned by big banks — JPM, BofAML and the like — which also hold the second lien on the loans.

So there’s a built-in disincentive. Accordingly, Goodman recommends:

. . . moving principal reduction higher in the HAMP modification waterfall would be the most natural way to raise the success of the modification program. Would investors support this type of program? Absolutely! While a foreclosure is devastating to a borrower, it is also devastating to an investor — the recovery rate on a subprime loan is leass than 30 cents on the dollar. It is approximately 50 cents on the dollar for a prime loan with a 200-400k loan size. The interests of the first lien investor and the borrower are totally aligned. It would be completely reasonably to further incentivize the investor to reduce loan balances through a government sponsored plan to liquefy properly de-risked laons. These would be loans in which the borrowers have performed as expected for some reasonable period after modification.

any principal reduction program requires the Adminstration to address the second lien problem head on. The solution is clear — the banks that own the second liens will have to write them down. The treasury may choose to pay an `extinguishment fee”; it may make sense to allow the banks to take the losses over time. But, for the sake of giving homeoweners the best chance to stay in their home, the second lien will have to be extinguished. It should be noted that second liens have thus far, under HAMP, been treated with kid gloves. The first lien modification program is fully operational, to the best of my knowledge the second lien program has not yet been implemented.

And if you think even with an `extinguishment fee’ the banks won’t go for principal forgiveness — much less second lien destruction — just have a look at the below testimony from Anthony B Sanders, distinguished professor of real estate finance at the Finance School of Management at George Mason.

He wants the principal forgiveness `carrot’ for financial institutions to be the ability to spread the losses in accounting terms for up to five years.

His reasoning:

When financial institutions and other holders of mortgages (investors) accept loan modifications, short sales and short payoffs, they take an immediate hit, causing them to reduce earnings and receive pressure from regulators to raise additional capital. To provide an incentive for financial institutions.investors to sell their distressed mortgage loans to the private markets, the government regulators, including the SEC, should allow financial institutions/investors to amortize the losses for up to 5 years to spread the accounting consequence of a loss over time. This would enable the financial institutions/investors to sell distressed assets from their books and free up funds to be invested elsewhere such as loans to small businesses.

While programs Like HAMP are meant to keep people in their houses, we need to provide an incentive to financial institutions to avoid becoming “zombie banks” as has occured in Japan. While the HAMP program might keep some people in their homes, the program maintains the loan with the lender and does not free funds for uses other than housing until the loan is paid off or refinanced. And with some of the 40-year extension of loan life for some of the modifications, this would mean that these loans would be on the balance sheets of the lenders/investors for almost half a century.

. . .

Accounting changes to permit financial institutions/investors to remove their distressed assets from their books clearly dominate alternatives such as “cramdowns” or other judicial interventions into the mortgage market. Helping financial institutions/investors dispose of their distressed assets was one of the original purposes of TARP and we should now consider the wisdom of cleaning-up fianncial institution balance sheets rather than judicial itnerventions.

If such proposals start to gain political support, the next generation Hamp could well be on its way.

Judging from the above - it might be even more interesting to watch than its original.

Related links:
FT Alphaville coverage of the Hamp
Principal forgiveness: Exhibit A - FT Alphaville

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