Friday, February 12, 2010

How long will you be underwater?, II: Modifications

Original posted on Rortybomb:

So let’s assume that there’s an option value in being above water in your mortgage, if only because you can sell it without having to go into your pocket for additional payments. You’d have to do that for the massive transaction and closing costs in the exercise we are about to do, so we’ll assume that’s even.

I’m curious as to your thoughts, what are some other things that could influence the value of that option?

Mortgage Modification

So…mortgage modification. Through HAMP, the government subsidizes mortgage modifications that get the mortgage payment down to 31% of income. The formula for a fixed-rate mortgage payment is:

c = (r / (1 − (1 + r) N))P0

You can lower “c”, the payment, by reducing the interest rate, increasing the number of years on the loan, and decreasing the principal. And that’s the order of the modification waterfall: taxpayers subsidize lowering the interest to as low as 2%. In order to get the payment down to 31%, the servicers can also increase the terms of the loan out to 40 years, and they can also put principal into forebearance (so you’ll have a balloon payment) or reduce it outright.

From Treasury’s December report, we see that permanent modifications by waterfall steps have 100% interest rate reduction, 43% term extension, and 26% principal forbearance.

So, there’s this family. They are are underwater on their mortgage. They are also stuck in the two-income trap: their current mortgage payment is 40% of their household income, and one of the two equal wage earners loses their job. They can only find new work at half the wage, so their household income is now 75% of what it was a month ago. Their mortgage now goes to 53% of the household budget, and they can’t make ends meet.

Good and Bad Modifications

So they apply for a modification. There’s two ways this can go to get the mortgage payment down to around 31% of your income. The first is to simply reduce the interest rate to 2%. That looks like this:

Not bad. It decreases the time underwater.

But there’s another way to do the modification. Let’s say the servicer simply reduces the interest rate to 3%. They also add 5% to the principal through fees, taxes, etc. Then, in order to make the mortgage payment fit your budget, they add 8 years to the term of the mortgage, putting you from 27 out of 30 years to 35 out of 35 years. (I think that is how it is done with term extensions, from the Treasury documents I’ve seen).

Your mortgage payment is still the same as in the first example. But that looks like this in this model:

So we know that a shocking 70% of mortgages that are modified have their balances increased. That pushes the curve up in and of itself. I’m currently trying to get numbers on how much it is increased, and how much the terms are increased on average (and interest rate reduced).

Given the nature of servicers in these circumstances, and their current profit incentives, and the clumsiness of regulators and government officials in monitoring their performance, do you think these modifications would go in the good or bad graph? Like that X-Files poster, “I want to believe.” But I’m not seeing anything to convince me. This is a bad way to try and handle this situation.

You know what is good at handling these situations? Bankruptcy courts. Can we get mortgage cramdown already? We can create a special modified bankruptcy rule for mortgage principals if we are worried it would distort all the other consumer spending. You know what else is good at handling these situations? Blunt government dollars. Why don’t we take all the money we are wasting nudging servicers, and just buy the mortgages themselves?

Everything I see here makes me think the government should be going nuts trying to find a solution – this is a serious problem effecting unemployment and the general recovery – and I see little to think HAMP hasn’t been a failure and won’t continue to be.

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