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Is the cavalry coming to rescue troubled homeowners?

Despite soaring foreclosure rates, President Bush and other Republicans have not made this a top priority, and Treasury Secretary Henry Paulson has refused to draw on the $700 billion rescue fund to help homeowners, saying that saving financial institutions is more important. But this could change next year: President-elect Barak Obama and fellow Democrats say reducing foreclosures is crucial to attacking the financial crisis and economic downturn.

"The financial sector weaknesses all originate in the housing market," says Jack M. Guttentag, professor of finance emeritus at Wharton. "If we don't solve the housing problem, then the weaknesses in the financial sector are going to continue to multiply."

Testifying November 18 before the House Committee on Financial Services, Sheila C. Bair, chairman of the Federal Deposit Insurance Corp., agreed: "Minimizing foreclosures is essential to the broader effort to stabilize global financial markets and the U.S. economy." According to Wharton real estate professor Susan M. Wachter, it is essential to break the vicious cycle of foreclosures driving down home prices, spurring more foreclosures. "The housing crisis is still a major source of the broader economic crisis that we find ourselves in."

Other experts are not so sure. "I wouldn't bail out people who made stupid mistakes," says Kent Smetters, professor of insurance and risk management at Wharton, arguing that borrowers and lenders should suffer the consequences of risks gone bad. Trying to mitigate the consequences won't stop the financial train wreck, just shift it to slow motion, he argues.  "The alternative is to say we're going to let the train wreck happen. What that does is to allow us to clear the tracks sooner."

On November 26, the Federal Reserve and Treasury Department announced an $800 billion infusion in the credit markets, including $600 billion to buy debt issued by mortgage giants Fannie Mae, Freddie Mac and the Federal Home Loan Bank. The move immediately drove the interest rate on 30-year fixed-rate mortgages down to about 5.5% from 6%, and there were reports of a flurry of loan applications from people looking to refinance mortgages or buy homes.

Wachter said the move is a key step to reviving the housing market and eventually stopping the downward spiral of home prices.

The lower rates could help some homeowners cut monthly payments by refinancing, perhaps allowing some to stay in homes they otherwise would lose. But lower rates alone will not help many homeowners who owe more than their homes are now worth, because these borrowers will not qualify for new loans big enough to pay off the old ones. Reducing the number of expected foreclosures would probably require efforts tailored to this problem, such as a recent program proposed by the FDIC's Bair. Even if such programs are enacted, it is not clear how well they would work.

A key problem: Can enough investors in mortgage-backed securities be induced to lock in losses, or will they prefer to hold out for a market rebound? Reduced interest rates and write-downs in loan balances are central to many foreclosure remedies.

Loan-modification advocates say those investors will go along, since a modification that costs mortgage investors 20% to 30% is preferable to a foreclosure, which typically costs more than 50% of the original loan amount. But skeptics note that not all investors in a given mortgage pool would benefit from a modification even if the pool as a whole is made healthier, since investors with first rights to homeowners' monthly payments are better insulated from defaults than those at the back of the line.

There is also debate over whether loan servicing companies that receive homeowners' payments and disburse them to investors have the authority to agree to sweeping modifications. William Frey, chief executive of Greenwich Financial Services, a firm that creates and distributes mortgage-backed securities, says servicers have little leeway. "The problem is there was a failure to imagine the kind of catastrophic meltdown that we have had," he notes.

Ineffective Remedies

Foreclosures totaled 1.2 million in the first half of 2008, compared to 1.5 million in all of 2007. Some experts predict close to 3 million in 2009. They cite several causes. Interest-rate resets are raising monthly payments for millions of homeowners with adjustable-rate mortgages, and economic problems and rising unemployment leaving more people short of loan-payment money. Because home prices have plunged over the past two years, many borrowers cannot sell at a price high enough to pay off their loans, and their homes do not contain enough equity for them to refinance at lower, fixed interest rates.

Foreclosures and loan-payment delinquencies have wreaked havoc with lenders and investors holding mortgage-backed securities, causing financial catastrophes at financial institutions like Citigroup, American International Group, Wachovia and many others.

A number of loan-modification programs are already underway, but results have not been terribly encouraging. The FDIC says only about 4% of seriously delinquent loans are being modified each month

Meanwhile, only about 4,000 borrowers have been helped by the government's FHASecure program started in the fall of 2007, according to the Department of Housing and Urban Development. This program requires applicants to have good payment histories and to have built up some equity -- a high hurdle considering that falling home prices and out-of-reach payments are so much of the problem.

By the third week in November, the government's Hope for Homeowners program, started October 1, had received just 111 homeowner applications, HUD said. This program cuts monthly payments largely by reducing the loan balance. Participation by mortgage holders is voluntary, and they may recover some losses by receiving a portion of the property's future appreciation, but that feature makes the plan less appealing to homeowners.

The government-sponsored companies Fannie Mae and Freddie Mac this fall announced plans to modify the loan terms on mortgages they own with payments at least 90 days past due. This program reduces the borrower's payments to no more than 38% of monthly income. But Fannie and Freddie hold only a small portion of troubled mortgages -- less than 100,000 loans in foreclosure for the two firms combined at the end of September.

To settle a predatory lending case brought by 15 states attorneys general, Bank of America has agreed to an $8.4 billion modification program covering some 400,000 loans acquired when it took over Countrywide Financial in July. This program, involving refinancings or interest-rate or principal reductions, has turned out to be more difficult than expected, according to a Wall Street Journal report. Most of the loans are in mortgage-backed securities held by investors, some of whom think they are unfairly being asked to shoulder losses that should be the bank's, the Journal article stated.

JP Morgan Chase and Citigroup have also announced loan-modification programs. To avoid conflicts with investors, they focus on loans they own rather than ones sold off as mortgage-backed securities. Critics note that JP Morgan's program, addressing $70 billion in loans, reduces payments but does not reduce the borrower's total debt, leaving the borrower owing the full amount when the loan is refinanced or the home is sold. The Citigroup plan, expected to entail about $20 billion in loans, is looking at 500,000 homeowners who could run into trouble. Those deemed at risk could receive interest rate cuts, have loans terms extended a number of years or have some principal forgiven.

Some banks have said they will postpone foreclosures while they work with troubled borrowers. (A report in Forbes.com early this week noted that Citibank, JP Morgan Chase and Bank of America have announced a moratorium on foreclosures on "good faith" borrowers -- those who can afford to continue mortgage payments.) The common flaw with many of these programs is the reluctance or refusal to permanently reduce the principal, or amount the homeowner owes, says Kenneth Thomas, a housing consultant to banks and thrifts. He points out that homeowners tend to walk away when they owe more than their properties are worth.

Reducing principal means someone must take a loss, and Thomas suggests this should be shared by the homeowner, the lender or investor, and the government. "You can't put it all on the government and you can't put it all on the banks. And if you put it all on the consumers, what we're going to have, of course, is more foreclosures, and this recession is going to be longer than we expect." Guttentag, too, says a remedy won't work if it leaves the loan balance higher than the property's current value. "Getting rid of the negative equity is critical."

One of the most prominent modification proposals was offered by the FDIC in early November. It is modeled on the FDIC's experience adjusting mortgages it acquired after the July failure of IndyMac Bank of Pasadena, Calif. While that entailed some principal reduction, it emphasized big interest-rate cuts, slashing some to as low as 3% and reducing the average homeowner's monthly payment by 23%. The FDIC assumed responsibility for servicing 653,000 mortgages, including more than 60,000 that were more than 60 days past due, in foreclosure, in bankruptcy or otherwise troubled. About 40,000 loans qualified for modifications, and 5,000 had completed the modification process by mid-November. Thousands more borrowers were making reduced payments while processing continued, the FDIC said.

Early in November, FDIC Chairman Bair proposed a new program designed to fit an estimated 1.4 million borrowers who were at least 60 days late on payments as of June 2008, as well as 3 million homeowners expected to get into trouble in 2009. Of those 4.4 million qualifying loans, about 2.2 million would likely be modified, Bair said. The Bush administration has not approved the program but the proposal may well get a better reception from the Obama administration

The goal is to reduce monthly payments to no more than 31% of the borrower's income by cutting interest rates, extending loan terms or reducing principal payments. Servicing companies would be lured by a $1,000 payment to cover modification expenses, and lenders and investors would be enticed with a guarantee that the government would shoulder 50% of any further losses on modified loans that default again. Based on the IndyMac experience, that re-default rate is projected at 33%, bringing the estimated program cost to $24.4 billion. With the re-defaults counted, the program could prevent 1.5 million foreclosures, Bair said.

The government would share re-default costs only if the borrower had already made six monthly payments on the modified loan, a potential problem according to Wharton's Guttentag. "I don't think it's going to work because I don't think that the servicers are going to buy into it," he says, adding that "re-defaults are one of the issues that servicers always bring up with modifications.... Most of the re-defaults are probably in the first six months."

The emphasis on interest rate cuts rather than principal reductions would leave too many homeowners underwater, encouraging them to abandon properties, he notes.  

Even if a borrower's principal is not written down, an interest rate reduction will reduce the cash flow to investors in the loan, whether they are banks or holders of mortgage-backed securities. Facing these losses, investors may well have the same objections they do to the Bank of America program.

Bair insists that investors' approval is not required for modifications to be done. She maintains that loan servicing firms have the legal authority to modify loan terms if they think that will make pools perform better than they would under a flood of defaults and foreclosures. "While some have argued that servicing agreements preclude or routinely require investor approval for loan modifications, this is not true for the vast majority of servicing agreements," she said in her House testimony.

Wachter warns that most servicing contracts do not give servicers authority to modify loan terms. Frey, too, points out that the vast majority of servicing agreements allow only very small numbers of modifications, generally involving interest-rate reductions rather than principal write-downs.

The 'Evil Part of Securitization'

Part of the problem is that when the servicing agreements were written several years ago, no one anticipated a widespread need for modifications, according to Wharton finance professor Richard Marston. "That's the evil part of securitization. Once you get into trouble there should be a [modification] mechanism.... It should have been written into the contracts that some neutral party had the authority to change the mortgages."

But including such a mechanism could make the securities less attractive to investors, since projected cash flows would be less certain.

Frey notes that modifications are fairly easy to accomplish when loans remain on the lender's books or in the accounts of government-sponsored entities like Fannie Mae and Freddie Mac. "The parties are sitting across from each other [and] they can do whatever they want," he says. But the bulk of the troubled loans, such as subprime and Alt-A loans to borrowers with less-than-perfect credit, were packaged into mortgage-backed securities now held by investors scattered around the world, he adds. As a practical matter, only the servicing firms are in a position to agree to modifications, making questions about their legal authority critical.

A Congressional Research Services analysis done for the House Financial Services Committee in October 2007 noted the difficulty.  "The holders of different securities from the same mortgage pool are often paid different amounts -- interest vs. principal, or paid-first vs. paid-last, to name two examples," the CRS report said. "The loan servicer that renegotiates the loan may have the effect of benefiting some tranches and hurting others rather than sharing gains and losses evenly.... Further clarification may be required to assure servicers and trusts that they will not be subject to investor lawsuits if they provide workouts to troubled borrowers."

Even if servicers think they do have modification authority, they may be reluctant to use it for fear of favoring some investors over others, Frey suggests. Complicating matters even further, the servicers could be accused of using modifications for their own benefit -- to avoid losing fees as mortgages fall into foreclosure.

If the FDIC proposal does not gain support, there are ways to tweak the strategy. Guttentag and a colleague, for example, responded to a Treasury Department request for proposals by suggesting a system that would slash interest rates but also write down principal. It would be costly to lenders and investors but could avert deeper costs from foreclosures. As a sweetener for investors, the government would shoulder part of the write-down cost, and investors would be insured against deeper-than-anticipated losses.

Clearly, any approach has shortcomings. Marston notes, for example, that the FDIC, by focusing on borrowers who are at least 60 days late in their payments, could encourage some homeowners to fall behind simply to obtain modifications even if they are capable of keeping up with payments. "Boy, oh boy, what strange incentives," he says.

All foreclosure remedies are open to charges of unfairness, Marston adds. They help borrowers who may have made unwise decisions and those who have been financially careless, while doing nothing for homeowners who struggle to keep abreast of payments. And they are disproportionately favorable to people who live in California, Nevada, Florida and other areas where the housing bubble was biggest.

Wharton finance professor Jeremy J. Siegel warns against too much focus on foreclosures, arguing that the problem is small compared to other financial and economic issues of the day. A major stimulus package and further efforts to encourage bank lending would be far more valuable. "It seems to me these [mortgage] workouts are going to take a number of months," he says. "The [federal government] has got to take measures now."

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