There’s a new initiative on the table in Washington, one that could do a lot to reduce foreclosures nationwide while actually generating a profit for Uncle Sam.
Like a good magic trick, the so-called FHA Housing and Homeowner Retention Act (H.R. 5830) is not what it seems. Superficially, the legislation proposed by Rep. Barney Frank (D-MA) would have the FHA insure home mortgages worth $300 billion. That would allow as many as 2 million toxic loans to be refinanced, thus reducing the inventory of distressed properties in local markets, clearing weak loans from lender books and helping communities prop-up falling property tax revenues.
But what Frank — chairman of the House Financial Services committee and thus a Capitol Hill power — is really proposing is actually far different. Buried within the good news of government help is a message to lenders and borrowers: They’ll have to pay to end the mortgage mess, a price that potentially will be bring billions of dollars in new revenue to the federal government.
The Frank Proposal
Frank’s approach is very different than the initiatives undertaken so far by the Bush Administration. Both the Hope Now and Project Lifeline are entirely voluntary and require no costs from lenders or borrowers.
Meanwhile, the number of troubled borrowers aided by the highly-publicized FHASecure program has been microscopic. Official figures from HUD show that only 1,729 delinquent conventional borrowers — the borrowers FHASecure was supposed to help — had been refinanced under the program as of the end of March.
If passed, the Frank plan would authorize the FHA to insure up to $300 billion in troubled loans. Relief would be available only to homeowners who financed before 2008 and access to the program would come with a stiff price for lenders.
Under the Frank proposal, existing mortgage holders would have to establish a 3 percent loan loss reserve with the FHA, pay 2 percent for new loan closing costs and engage in a short sale because the new FHA-guaranteed loan will be no greater than 90 percent of property’s current appraised value.
By The Numbers
To understand how the Frank plan works let’s look at a model transaction: Smith bought a $300,000 home in 2005 with an interest-only loan. Smith paid with 2 percent down, meaning that the lender put up $294,000. At 6 percent interest, Smith’s monthly cost for the home is $1,470 plus taxes and insurance.
Three years later the property is worth $270,000 and the interest-only period is over. The new interest rate is 8 percent, the loan balance is unchanged but the remaining loan term has been reduced to 27 years. The new monthly cost for principal and interest is $2,218.
Smith is underwater. He can’t afford the monthly payment and he can’t sell the property for enough to repay the loan. He will be foreclosed.
Not only is Smith in trouble, so is the lender. If the lender forecloses then according to the Congressional Budget Office it’s likely to suffer a loss ranging from $90,000 to as much as $180,000, depending on local market conditions.
Given such numbers the Frank alternative may be the least painful of several awful choices.
Under the Frank plan the FHA will finance 90 percent of $270,000 or $243,000. The lender will also pay 5 percent of the new loan amount to Uncle Sam — that’s $12,150 for the reserve fund and closing costs.
So far the lender is out $51,000 in loan principal ($294,000 less $243,000) and $12,150 in FHA fees. That’s big money, but wait — as late-night TV infomercials say — there’s more.
Under the Frank plan prepayment penalties and other fees are out. Lenders who want relief from the FHA would have to forgive all prepayment penalties.
“All penalties for prepayment of the existing mortgage or mortgages, and all fees and penalties related to default or delinquency on all existing mortgages, shall be waived or forgiven,” says the proposed legislation.
If the prepayment penalty in this case is equal to six months’ interest, then the lender is out another $11,760 ($294,000 x 8 percent, the current interest rate, divided by 2).
Add it up and the lender with the Smith loan will lose at least $74,910 ($51,000 + $12,150 + $11,760).
Is This Realistic?
Will lenders go for the Frank plan and its huge costs?
“In areas where the real estate market is strong the Frank plan will have little traction because lenders will be able to foreclose and sell near market value,” says James J. Saccacio, chief executive officer at RealtyTrac.com, the leading online marketplace for foreclosure properties. “Today such areas include Vermont, West Virginia, both Dakotas, Mississippi, Maine, Nebraska, Kentucky, Hawaii, and Wyoming.
“However, in areas where foreclosure levels are high and the ‘foreclosure discount’ is steep, lenders will likely see the Frank plan as a better alternative than the marketplace. Areas where the Frank plan will be in demand include Nevada, California, Florida, Arizona, Georgia, Colorado, Indiana, Michigan, Ohio, Tennessee and portions of Texas and Maryland.”
Another factor that will impact lender decisions is the type of loan being lost. Interest-only and option ARMs will be the most-likely loans to be refinanced with new FHA mortgages because when such loans fail they produce the biggest lender losses. This happens because there’s no principal reduction with interest-only financing during the first few years of the loan term while option ARMs allow negative amortization that can cause the principal balance to balloon, thus inflating losses when such mortgages are foreclosed.
What About Borrowers?
If lenders go for the Frank plan all their claims against the borrower will end. The borrower, however, does not get away without substantial cost.
Under the FHA program today borrowers typically pay two forms of insurance fees: a 1.5 percent up-front premium and a .5 percent premium paid out over the course of a year with monthly payments.
The Frank plan introduces two addition costs, one potential and one actual. First, to discourage speculators and abuse, the Frank plan gets a share of the profits if the property is sold during the first five years — 100 percent the first year, 80 percent the second year and so forth. Second, at the end of five years profit-sharing ends but an “exit” fee equal to 3 percent of the original loan balance remains in place until the property is sold or refinanced.
Will Borrowers Go For This?
Given a choice of foreclosure or the Frank plan, borrowers would be foolish to take foreclosure.
Go back to the Smith loan. When we last left him he was upside down on his mortgage and facing a monthly cost of $2,218. Under the Frank plan he’s not out on the street plus he now has a $243,000 mortgage. If his new rate is 6.5 percent (6 percent interest plus .5 percent for the FHA monthly insurance premium), then he has a monthly payment of $1,536 plus taxes and insurance.
While $1,536 is more than Smith’s original payment of $1,470, the smaller amount was an interest-only payment — the debt was not being reduced. With the new loan the principal balance is self-amortizing, it goes down every month and if the loan is held for its entire term the debt will be completely paid off.
As to closing costs, the lender is paying 2 percent of the loan amount and much of the rest can be financed. For many borrowers, the cost to refinance will be fairly close to zero.
Will The Government Lose Money?
Critics of the Frank plan worry that if housing prices continue to fall the government could be faced with massive losses. While some foreclosures and property losses should be expected, the more likely result is that the Frank plan will mean billions of dollars in new revenue for Uncle Sam.
Under the Frank plan we had a home worth $270,000 in today’s market that has been refinanced with a $243,000 mortgage, meaning there’s a 10-percent equity cushion, far more than the 2 percent initially put down by the borrower. In addition, the lender has paid 3 percent of the loan amount into a reserve fund and the borrower paid a 2 percent insurance premium up front. Add it up and the FHA has a 15 percent cushion — and that’s before considering amortization, a factor that will reduce the FHA’s risk increasingly over time.
In addition, if a property is sold there’s also the 3 percent exit fee plus profit-sharing if the sale is made within five years. Some homes within the program will be sold during the initial five-year period, thus earning profit-sharing dollars. All homes will pay the exit fee, regardless of when sold.
Because a large number of homes will potentially be eligible for refinancing under the Frank plan, housing inventory in many local markets will begin to shrink, thus reducing the pressure to lower prices and increasing equity. For borrowers, the smart strategy will be to keep the property for at least five years, restore credit, whittle down the debt and hope that home prices again begin to appreciate. Coincidentally, the strategy that’s wise for borrowers also helps reduce FHA losses.
In fourth quarter of 2007 the FHA foreclosure rate stood at 2.34 percent according to the Mortgage Bankers Association. Since even foreclosed homes have some residual value, it follows that few homes represented a 100-percent loss. In effect, while some loans financed under the Frank program will fail, such losses have been anticipated. And although a loss to the entire program is theoretically possible, in practice such a debacle is highly-unlikely because of the discounts, limits and reserves built into the plan. What’s more plausible is that the program if passed in its original form will actually produce excess revenues and surpluses — a real profit for Uncle Sam.
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.