I’d like to tell you otherwise. I’d like to say that the new Obama foreclosure prevention efforts will finally resolve the real estate mess and thus the housing mess, the banking mess and the insurance mess. I’d like to say that we finally have a visible marker that shows the very moment when the housing downturn came to an end.
I can’t do that. What I can say is that the Obama plan goes further, much further, than any government effort to date. It ought to be applauded. It will help large numbers of homeowners. But when you see claims that millions and millions of borrowers will benefit, look out. The final numbers are likely to be far smaller than today’s estimates suggest.
We now have the details of the Obama plan. In basic terms the idea is to divide the world of mortgage borrowers into three groups: those facing foreclosure, those with affordability issues and those who are OK. The third group is fine; it is borrowers in the first two categories who will potentially receive help.
- Fannie Mae and Freddie Mac will both offer “Home Affordable Modification” programs to assist those facing foreclosure.
- Fannie Mae and Freddie Mac will also offer “Home Affordable Refinance” refinance programs that are designed to lower mortgage rates.
How will the programs work? Let’s take a look:
In the past year mortgage rates have come down significantly, yet many homeowners are unable to refinance. The problem is not cash or credit, it’s that the value of the property is less than the outstanding mortgage balance.
These properties could be substantially more affordable — and thus less likely to be lost to foreclosure — if the borrowers could refinance. Also, if borrowers had lower monthly mortgage costs they would have more dollars to spend on other products and services, thus stimulating the economy, a major government goal at this time.
Traditional loan standards will not allow upside-down borrowers to refinance, a problem which the Home Affordable Refinance effort is designed to resolve.
- To qualify for a mortgage refinance a borrower must be “current” on their mortgage, an expression which means no payments which were at least 30 days late during the past year.
- Refinancing must produce a clear benefit to the borrower such as a lower interest rate, a shorter loan term or the replacement of an ARM, option ARM or balloon note with fixed-rate financing.
- If the borrower’s monthly payment increases less than 20 percent then the borrower does not have to requalify for the mortgage. Hopefully, monthly payments will decline for most borrowers given that rates have come down.
Perhaps most importantly, the Home Affordable Refinance effort will permit borrowers to qualify for a new loan even if the house is worth less than the existing mortgage balance. Loan-to-value ratios of as much as 105 percent will be allowed, meaning that if a borrower owes $210,000 and a home is worth only $200,000 then the property can still be refinanced.
The obvious flaw in this plan is that huge numbers of recent borrowers are deeply under water. For instance, many owners in what RealtyTrac.com shows as the nation’s top ten foreclosure states — California, Nevada, Arizona, Florida, Oregon, Illinois, Michigan, Georgia, Idaho and Ohio — will never qualify for the refinancing program.
While the loan refinancing program was for folks who are making their payments, the loan modification plan is for those who are behind on their payments by at least 30 days. However — and this is a key point — borrowers facing tough times can also apply for modifications even if they have NOT been late on their loans.
The modification plan appears to create a subsidy for borrowers. If a lender can reduce your monthly ownership cost to the point where it equals not more than 38 percent of your gross monthly income the government will pitch in with a subsidy that will knock down payments to 31 percent of your monthly earnings.
To get relief under the modification plan you need to be in financial trouble. As examples, those now facing foreclosure, those who have lost a job and those who are in bankruptcy are likely qualify. If you have a toxic loan you may qualify for help, the government says individuals can qualify if they are “facing a recent or imminent increase in the payment that is likely to create a financial hardship (payment shock).”
Unlike the refinancing plan, “there is no minimum or maximum LTV ratio for eligibility purposes,” according to the government. In effect, the program is open to just about every homeowner with severe financial problems.
For those who qualify there are two benefits to this plan. First, the lender is reducing borrower expenses, perhaps by something as simple as increasing the loan term to 40 years. Second, once the lender has made required changes the government enters with a monthly contribution that holds down borrower costs.
Here’s an example of how the program works: Baker has a $300,000 loan at 7 percent over 30 years. The monthly cost for principal and interest is $1,996. Property taxes and insurance are another $500 a month. In total, $2,496 for housing expenses. Baker makes $6,100 per month or $73,200 per year.
In this situation Baker’s housing costs represent 40.51 percent of his monthly income. If we assume that insurance expenses and property taxes won’t be reduced, to lower his monthly housing costs it will be necessary to drop his required monthly mortgage payments. (In practice, taxes and insurance costs are likely to fall over time in many areas since they are related to home values.)
To cut Baker’s costs, his lender extends the loan term to 40 years and reduces his interest rate to 6.5 percent. The result is that his monthly mortgage payment for principal and interest falls to $1,756 and his total housing cost drops to $2,256 ($1,756 + $500) or 37 percent of Baker’s monthly income. The government then steps in and gives the lender a monthly subsidy of $365 so that Baker’s new housing cost of is equal to 31 percent of his gross monthly income ($6,100 x .31 = $1,891. $2,256 less $1,891 = $365).
Lenders, Investors & Servicers
In the scenario that plays out under the Obama plan, lenders, investors and servicers (the folks who administer loans for investors) would be smart to participate even though monthly income is being reduced. Here’s why:
- If Baker is behind on his loan and foreclosure looms without federal assistance, then costs to the lender/investor might total $40,000 to $80,000 in a typical situation.
- If Baker is current on his mortgage than the lender/investor can qualify for a $1,500 Current Borrower One-Time Incentive.
- The loan balance will be reduced by an extra $1,000 per year for five years if Baker keeps up his payments, what the plan calls a Pay-for-Performance Success Payment. For lenders, this is the equivalent of a borrower prepayment, something which lowers risk. Since the performance payment is $1,000 per year regardless of the size of the loan, it’s worth more to lenders for smaller loans because the payment is a bigger percentage of any outstanding mortgage balance.
- If Baker is not foreclosed, and if lots of neighbors are not foreclosed, the value of Baker’s home can stabilize and perhaps even go up. This means the house — which is the lender’s security for the loan — could be more valuable, something which again reduces the lender risk.
- While lenders can reduce mortgage levels below 38 percent as we have done in this example, in practice we expect that a lot of loans will have new rates and terms that magically amount to 37.99 percent of the borrower’s gross monthly income. This will limit the cash flow loss to the lender.
- The lower monthly payments required from Baker, effectively 31 percent of his gross monthly income, make his mortgage more affordable, something which reduces the potential for failure and foreclosure.
- No principal reduction is required under the Obama plan. This is crucially important to loan owners such as banks and insurance companies because if principal is reduced it means that asset values across the board would have to be reduced, something that would demolish balance sheets.
“The new plan takes us further than we have gone before in terms of a government foreclosure effort,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the leading source for foreclosure information and listings. “That said, while the plan has the potential to help large numbers of homeowners it’s also true that millions of loans are not owned by Fannie Mae and Freddie Mac. To end the mortgage meltdown we also need to deal with the loans held by private investors.”
Real Life Limitations
The Obama plan goes far beyond earlier government efforts to help borrowers such as FHASecure and the Hope for Homeowners program. It puts money on the table and makse an effort to balance the interests of borrowers, investors and servicers.
The White House says that as many as 9 million homeowners will be helped under the modification and refinancing plans. It would be great if this were true, but the odds are that the programs will impact far fewer borrowers. Here’s why:
First, many potential beneficiaries are excluded from the plans, including real estate investors and second-home owners, those with steep property losses who need to refinance and borrowers with loans that mortgage investors refuse to modify.
Second, the Obama plan is directed toward Fannie Mae and Freddie Mac. They are the dominant players in the mortgage marketplace but many of the loans they administer are not loans they actually own or control.
Fannie Mae and Freddie Mac have a retained portfolio of loans worth $1.6 trillion. These are mortgages that the government can modify at will because they are owned outright by Fannie Mae and Freddie Mac. However, the two companies have also issued mortgage-backed securities worth $3.7 billion. Can the loans used to support these securities be modified without the permission of the security owners? Countrywide, as one example, is being sued by investors who say that the company has no right to modify their loans. Countrywide argues that it does have the authority to make such changes.
Third, despite yelling and screaming to the contrary, Fannie Mae and Freddie Mac have excellent loan portfolios with few foreclosures relative to their huge size. This means that they have comparatively few loans to modify.
Here’s what the Federal Housing Finance Agency — the government body that regulates Fannie Mae and Freddie Mac — told Congress in February.
“While Fannie Mae and Freddie Mac own or guarantee almost 31 million mortgages, about 56 percent of all single-family mortgages, the mortgages they own or guarantee represent just 19 percent of serious delinquencies. Private-label mortgage-backed securities (PLS) represent 16 percent of all outstanding mortgages but more than 62 percent of the serious delinquencies.”
Translation: It’s not Fannie Mae and Freddie Mac that are at the heart of the foreclosure mess. Housing problems will not be resolved until private investors modify their loans, something the government cannot compel unless it’s willing to buy the mortgages.
Fourth, servicers are not going to modify anything unless they’re sure they won’t be sued by mortgage investors, the people who actually own the loans. In other words, they need and want “safe harbor” provisions to protect them against litigation.
Fifth, in many cases borrowers have two loans, not one. The government cannot compel those who hold second loans to discount or write-off their mortgages.
Sixth, many toxic loans have huge prepayment penalties that effectively block modifications until penalty periods end. Again, the government cannot compel private mortgage owners to write off such charges.
Even if the government’s foreclosure prevention efforts were able to overcome the hurdles mentioned here, there remains the problem of a stalled economy and growing levels of unemployment. If a loan can be modified or refinanced it won’t make much difference if the borrower loses his or her job and has insufficient income to make even lower monthly payments.
Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com.