The continuing spike in delinquencies and foreclosures has caused the topic of loan modifications to receive renewed attention and focus. In testimony before Congress, Federal Deposit Insurance Corp. (FDIC) Chairwoman Sheila Bair recently unveiled a plan designed to entice servicers to reduce the monthly mortgage payments and debt-to-income ratios of numerous delinquent borrowers.
The critical question facing Congress and the incoming Administration is whether this program, or any initiative, will substantially reduce the ranks of homeowners in or approaching foreclosure. The record of "homeowner aid" plans is not encouraging. Most of the plans (from FHASecure through Hope 4 Homeowners) have helped relatively few borrowers, reflecting the difficulty in instituting large-scale efforts to modify assets that were routinely structured and sold into the capital markets. The FDIC plan also has a number of flaws. Aside from being quite complex, it attempts to qualify borrowers using income ratios; since many problem loans were made without income documentation, such ratios are necessarily suspect.
More troubling is the high recidivism rate for modified loans. For example, the Office of the Comptroller of the Currency recently released data indicating that 58% of loans modified in the first quarter of 2008 were more than 30 days delinquent after eight months. If accurate, the data suggest that government funds directed toward mass modification efforts would be largely wasted.
A simple and straightforward approach to large-scale loan modifications would be to convert existing loans into interest-only obligations. This initiative could be implemented fairly quickly, and would have a substantial impact on borrowers' income ratios without government expenditures. For example, a $250,000 loan with a 6% note rate made to a couple earning $50,000 annually would have a payment/income ratio of 36%. Requiring an interest-only payment would reduce the ratio to 30%, the equivalent of a reduction in the loan's note rate to 4.5%. To mitigate future rate shock, the maturity of modified loans could be extended so that they ultimately amortize based on their original schedule. For example, a loan could be modified to have a five-year interest-only period and subsequently amortize over its original 30-year term, giving it a 35-year maturity.
This approach would give many troubled borrowers significant relief from unmanageable debt burdens. The initiative could also be combined with government programs designed to subsidize borrowers by buying down their note rates. In the above example, reducing the rate of the interest-only loan to 5% would result in a 25% ratio. Eligibility requirements for the subsidy (as well as the interest-only provision) would, of course, need to be established.
This type of program should not materially damage the interests of servicers and investors. While amortization is taken into account in structures, credit support levels are not highly dependent on scheduled principal. If extending their term is problematic, loans could be structured to have balloon provisions effective on the original maturity date.
However, this program probably won't address the critical recidivism issue. While a variety of reasons for the dismal re-default statistics have been offered, a major factor has been the plunge in home prices, which has put many homeowners in the position of having either zero or negative equity. The ability of homeowners to walk away from negative-equity situations amounts to having put options on their properties that are apparently being exercised in a startlingly efficient fashion. This suggests that many re-defaults are voluntary in nature, a distasteful possibility that no program can (or should) address. However, the interest-only initiative outlined above would result in a relatively low cost to investors and taxpayers, even if it is only modestly effective.
Bill Berliner is a financial consultant based in Southern California. His Web site is:
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