Interest Rate Roundup

Wednesday, February 18, 2009

Details of Obama plan released, with my comments

The earlier post I put up was based on media reports. Now, the Obama administration has officially released its plan to reduce foreclosures. The details can be found here (PDF link). Let's get into the major components ...

The centerpiece of the program is designed to encourage loan modifications through government subsidies and payments -- payments that go to mortgage servicers, borrowers, and investors. Here are the details:

- A Shared Effort to Reduce Monthly Payments: For a sample household with payments adding up to 43 percent of his monthly income, the lender would first be responsible for bringing down interest rates so that the borrower’s monthly mortgage payment is no more than 38 percent of his or her income.

Next, the initiative would match further reductions in interest payments dollar-for-dollar with the lender to bring that ratio down to 31 percent. If that borrower had a $220,000 mortgage, that could mean a reduction in monthly payments by over $400. That lower interest rate must be kept in place for five years, after which it could gradually be stepped up to the conforming loan rate in place at the time of the modification. Lenders will also be able to bring down monthly payments by reducing the principal owed on the mortgage, with Treasury sharing in the costs.

- "Pay for Success" Incentives to Servicers: Servicers will receive an up-front fee of $1,000 for each eligible modification meeting guidelines established under this initiative. They will also receive "pay for success" fees – awarded monthly as long as the borrower stays current on the loan – of up to $1,000 each year for three years.

- Incentives to Help Borrowers Stay Current: To provide an extra incentive for borrowers to keep paying on time, the initiative will provide a monthly balance reduction payment that goes straight towards reducing the principal balance of the mortgage loan. As long as a borrower stays current on his or her loan, he or she can get up to $1,000 each year for five years.

- Reaching Borrowers Early: To keep lenders focused on reaching borrowers who are trying their best to stay current on their mortgages, an incentive payment of $500 will be paid to servicers, and an incentive payment of $1,500 will be paid to mortgage holders, if they modify at-risk loans before the borrower falls behind.

- Home Price Decline Reserve Payments: To encourage lenders to modify more mortgages and enable more families to keep their homes, the Administration -- together with the FDIC -- has developed an innovative partial guarantee initiative. The insurance fund – to be created by the Treasury Department at a size of up to $10 billion – will be designed to discourage lenders from opting to foreclose on mortgages that could be viable now out of fear that home prices will fall even further later on.

Holders of mortgages modified under the program would be provided with an additional insurance payment on each modified loan, linked to declines in the home price index. These payments could be set aside as reserves, providing a partial guarantee in the event that home price declines – and therefore losses in cases of default – are higher than expected.

All told, it appears the government could end up paying as much as $10,500 to borrowers, lenders, and servicers in fees and subsidies per loan, as well as the undetermined cost of subsidizing the interest rate and/or covering the cost of reducing principal.

* The modification plan will not be accessible by speculators. In other words, it's targeted at owner-occupants vs. investors. It will only apply to mortgages under the conforming loan limit -- meaning no "jumbos." It appears the current conforming loan limits, rather than the limits in place when the borrower took out the loan, will be used to determine eligibility. The current Fannie Mae and Freddie Mac conforming loan limit is $417,000 nationally, and up to $729,750 in areas designated "high cost."

* Borrowers will potentially qualify for a modification if they have elevated mortgage debt to income ratios (38% or greater) OR they are underwater on their loans (including any first and second mortgage debt). They do not have to be currently delinquent on their payments.

* Anyone who is tagged for the program -- and who has a total debt-to-income ratio of 55% or higher (meaning, if you add their mortgage payments to payments on credit cards, auto loans, and so on, it consumes more than 55% of gross income) -- will be required to attend a debt counseling program in order to get a mod. Loan modifications will not be allowed to cut a borrower's interest rate to less than 2%.

A sheet with various examples of how this would work can be found here (PDF link).

Fannie Mae and Freddie Mac will also see some changes as part of this program. Here is what is happening there ...

* The Treasury Department will double the amount of money it has committed to inject into Fannie Mae and Freddie Mac (via the purchase of preferred shares) -- to as much as $400 billion from $200 billion. The two GSEs will also be allowed to increase the size of their retained loan portfolios to $900 billion from $850 billion currently. The government had previously said the agencies would be allowed to modestly increase their portfolios through the end of this year, then reduce them by 10% a year starting in 2010 in order to reduce systemic risk.

Moreover, borrowers who are upside down -- owing more than their houses are worth -- may be able to refinance going forward. How?

* Fannie and Freddie will be allowed to refinance mortgages they hold -- or that they put into MBS -- as long as the new loans (including any refi fees) don't amount to more than 105% of the current value of the underlying homes.

* Borrowers can participate in this program if they have a second mortgage, but only if the second mortgage lender agrees to stay in second position. The refi loans will feature fixed rates with terms of 15 or 30 years, with no prepayment or balloon payments. Applications won't be accepted until March 4, when details of the program are released.

What about the potential impact of these two programs? Here is the administration's take on that ...

* The administration says this plan will help 7 million to 9 million families either restructure their loans or refinance them. The breakdown suggests 4 million to 5 million homeowners will be able to refinance, while 3 million to 4 million will be helped by the modification program. The administration says the plan will prevent house prices from declining an additional $6,000 (above and beyond the declines they're already are suffering due to the economy).

The government is also going to try to make loan modifications more uniform across the mortgage industry. More details follow ...

*All banks receiving Financial Stability Plan (meaning, TARP) aid from here on out will be forced to implement a uniform loan modification program. This program will likely follow the blueprint of the FDIC's "Mod in a Box" program, as well as current modification programs being pursued by Fannie and Freddie. The government will seek to apply any modification program to FHA and VA loans, in additional to conventional loans owned or guaranteed by the GSEs. Details of the guidelines will be released before March 4.

What about the very important question many of us has raised: Will borrowers see their principal balances cut?

* That's permitted under the plan, but not the focus of the administration's effort. Borrowers will more likely see term extensions and interest rate cuts.

* Meanwhile, the Obama administration will back legislative efforts to allow bankruptcy judges to cram down mortgage balances. Specifically, the administration prefers that any legislation allow judges to treat any mortgage amount due above and beyond the current value of the borrower's home to be split out and considered unsecured debt. A payment plan for that unsecured amount can be worked out, just like you'd see with other unsecured debts.

* Finally, the Hope for Homeowners plan will be modified, with the FHA cutting fees that borrowers have to pay and loosening standards so that borrowers with higher debt burdens can qualify, among other things.

UPDATE: So now we have the details of Obama's plan. The big question is, Will this latest plan work? What are the pitfalls? Well, I have to say I like a few principles that are included here.

First, the mortgage lender/investor appears required to take the "first hit" on whatever modification would get the borrower's payment down to a 38% DTI ratio. Then the government shares the cost for the next seven percentage points.

Second, the program is targeted at buyers who aren't yet delinquent on their loans, but may end up in that category. This eliminates the whole "My lender won't talk to me until I miss three payments" problem.

Third, borrowers will receive up to $5,000 in principal reduction payments from the government over time. The idea is to help incentivize borrowers who are upside down to stay put during the period they are upside down, but paying at the reduced rate.

So what are the flaws? Well, this only applies to owner occupied homes with loans under the conforming loan limit. Some 40% of existing homes sold during the peak of the bubble -- 2005 -- were purchased as second homes or investment properties, according to the National Association of Realtors. Jumbo loan delinquencies are also rising quickly. Any foreclosures there would not be mitigated by this plan. That's understandable from a political standpoint (officials don't want to be seen bailout out the speculators or the rich). But it also limits the plan's impact.

Another troubling aspect of this plan is the provision that would allow Fannie Mae and Freddie Mac to refinance borrowers into new loans with LTVs of up to 105%. Waiting and hoping for a home price rebound -- and refusing to just go ahead and foreclose on loans where borrowers have fallen behind and are upside down -- has proven to be a losing strategy. It's akin to kicking the can down the road, and it has resulted in billions and billions of dollars in industry losses.

Now, rather than cut their losses short, Fannie and Freddie will be allowed to refinance these outstanding mortgages into new lower-rate loans that feature LTVs of 100% or more. A portion of the new loans will effectively be unsecured as a result. That exposes Fannie and Freddie to potentially larger losses down the road if home prices don't rebound and/or if borrowers just end up defaulting anyway. That, in turn, could result in some additional risk being priced into the GSEs' cost of funds.

Bottom line: Taxpayers could ultimately get soaked here if home prices don't rise in the coming few years. Those losses would come on top of any possible losses stemming from the recent surge in FHA loan volume. FHA, unlike most private lenders these days, still writes loans at LTVs as high as 97%, a significant risk in an environment of falling home prices and rising unemployment.

Furthermore, the plan still doesn't attack the principal reduction issue head on. Lenders and servicers may voluntarily apply any government aid toward principal reductions. But it appears term extensions and rate reductions will be the main technique used to reduce payments to the 38% and 31% thresholds. The Obama administration is hoping that the threat of bankruptcy cramdowns will inspire lenders to act. But that remains to be seen.

Moreover, in many hard-hit markets (the same ones where foreclosure rates are the highest, including Florida and California), the home price declines are extremely severe. A $5,000 principal reduction incentive payment, spread out over five years, likely won't be enough to incentive those borrowers to stick around should hardship strike.

And even if they do, what happens when these borrowers want to move? It took several years for borrowers in regional markets like New England and California to get back to breakeven during previous busts, assuming they purchased at or near the market peaks. With foreclosure and/or a principal write-down, the debt they can't pay back or that exceeds the value of their current home gets wiped away. They are then free to rent for a while and buy a new home later.

Under this plan, it doesn't look like the debt they owe in excess of their current home's value will typically be wiped away. That means they're going to have to come up with large amounts of money when they eventually want to move. That would be covered if home prices rise substantially. But again, we're talking about borrowers who are deeply underwater -- and who will likely remain so for years. More than likely, many of these borrowers will stay put, depressing home sales activity in hard hit markets going forward.

Last but not least, there is the whole moral hazard argument. The government could end up subsidizing mortgage borrowers, lenders, and servicers to the tune of more than $10,000 as part of this program. How is that fair to borrowers who played by the rules ... who didn't buy too much house ... and continue to pay their loans on time? Why are they left out in the cold? That's what many Americans are going to be asking, and what many politicians are going to be hearing from callers.

I would also like to point out, in closing, that market forces ARE working. Foreclosures are actually resulting in overpriced homes burdened with too much debt being moved into the hands of new buyers, who are paying drastically reduced prices. They can therefore purchase using a traditional mortgage. In markets where prices have fallen the most, home sales are currently rising smartly. Delaying and dragging out the downturn by artificially propping up home prices will arguably work against the market healing, even if it makes us all feel good for doing "something."


  • Excellent analysis, Mike.

    By Anonymous Anonymous, at February 18, 2009 at 1:44 PM  

  • Mike,

    Always enjoy your insightful, pithy comments. That said, I am left wondering whether you on the whole support the administration's proposed plan ?

    By Anonymous Anonymous, at February 18, 2009 at 3:58 PM  

  • I have a "technical" question about the plan. I currently hold a 7- year interest-only ARM. I would like to refinance into a 30-year fixed rate mortgage. It appears I can do this under the plan even though my home has lost value(it will still fall under the guidelines). My question is- will I still be able to apply for a loan modification as well. The refi will actually cause my housing debt to be well above 38%. So, will a loan modification be a better choice?

    By Anonymous Anonymous, at February 19, 2009 at 9:28 AM  

  • Hello, thank you for your posting I have a problem with the fact that I have a conventional loan not a Fannie Maee, Freddie Mack loan and none seems to pay attention or willing to help homeowners like my self. I am a disable person with a stable income from Social Security Disability but I cannot see yet where the President's new law will help me because I have a conventional loan and I am already behind. Countrywide suppose to be doing loan modification for me now but they refuse to do the principal balance reduction to the current market value of my home.
    What are the options for the conventional loan borrowers?
    Thank you for your time. Libby A.

    By Anonymous Anonymous, at February 20, 2009 at 4:33 AM  

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