Interest Rate Roundup

Tuesday, March 04, 2008

Bernanke grim on housing, urges principal balance reductions as loss mitigation tool

Federal Reserve Board Chairman Ben Bernanke is giving a speech at the Independent Community Bankers of America Annual Convention in Orlando, Florida this morning. An advance copy of his speech has been posted online. Here are some key points (with highlights in bold)


"Mortgage delinquencies began to rise in mid-2005 after several years at remarkably low levels. The worst payment problems have been among subprime adjustable-rate mortgages (subprime ARMs); more than one-fifth of the 3.6 million loans outstanding were seriously delinquent at the end of 2007. Delinquency rates have also risen for other types of mortgages, reaching 8 percent for subprime fixed-rate loans and 6 percent on adjustable-rate loans securitized in alt-A pools. Lenders were on pace to have initiated roughly 1-1/2 million foreclosure proceedings last year, up from an average of fewer than 1 million foreclosure starts in the preceding two years. More than one-half of the foreclosure starts in 2007 were on subprime mortgages.

"The recent surge in delinquencies in subprime ARMs is closely linked to the fact that many of these borrowers have little or no equity in their homes. For example, data collected under the Home Mortgage Disclosure Act suggest that nearly 40 percent of higher-priced home-purchase loans in 2006 involved a second mortgage (or "piggyback") loan. Other data show that more than 40 percent of the subprime loans in the 2006 vintage had combined loan-to-value ratios in excess of 90 percent, a considerably higher share than earlier in the decade. Often, in recent mortgage vintages, small down payments were combined with other risk factors, such as a lack of documentation of sufficient income to make the required loan payments."


"This weak underwriting might not have produced widespread payment problems had house prices continued to rise at the rapid pace seen earlier in the decade. Rising prices provided leveraged borrowers with significant increases in home equity and, consequently, with greater financial flexibility. Instead, as you know, house prices are now falling in many parts of the country. The resulting decline in equity reduces both the ability and the financial incentive of stressed borrowers to remain in their homes. Indeed, historically, borrowers with little or no equity have been substantially more likely than others to fall behind in their payments. The large number of outstanding mortgages with negative amortization features may exacerbate this problem."


"Delinquencies and foreclosures likely will continue to rise for a while longer, for several reasons. First, supply-demand imbalances in many housing markets suggest that some further declines in house prices are likely, implying additional reductions in borrowers' equity. Second, many subprime borrowers are facing imminent resets of the interest rates on their mortgages. In 2008, about 1-1/2 million loans, representing more than 40 percent of the outstanding stock of subprime ARMs, are scheduled to reset. We estimate that the interest rate on a typical subprime ARM scheduled to reset in the current quarter will increase from just above 8 percent to about 9-1/4 percent, raising the monthly payment by more than 10 percent, to $1,500 on average. Declines in short-term interest rates and initiatives involving rate freezes will reduce the impact somewhat, but interest rate resets will nevertheless impose stress on many households."


"In the past, subprime borrowers were often able to avoid resets by refinancing, but currently that avenue is largely closed. Borrowers are hampered not only by their lack of equity but also by the tighter credit conditions in mortgage markets. New securitizations of nonprime mortgages have virtually halted, and commercial banks have tightened their standards, especially for riskier mortgages. Indeed, the available evidence suggests that private lenders are originating few nonprime loans at any terms.


"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. 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 ...

"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."


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."


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