Thursday, February 21, 2008

How to help both homeowners and lenders at no public cost

(Felix Salmon) I really like this idea from the Office of Thrift Supervision: it looks like it can reduce foreclosures and help provide liquidity to struggling mortgage lenders at the same time. Here's how it works: take a borrower who's underwater, with a mortgage for more than their house is worth. Refinance the mortgage so that it comes down to the value of the house, and then give the lender a tradeable warrant for the difference. Mortgage payments come down, because the mortgage has come down, and the lender, if it needs cash, can simply sell the warrant on the secondary market. If the house gets sold for more than the value of the new mortgage, the excess goes in the first instance to the warrant holder; the homeowner makes money only if the house is sold for more than it was bought for.

The big problem, as I see it, is securitization - the legal obstacles to doing this with a securitized loan are huge. But they may not be insurmountable, especially if this scheme is shown to work for mortgages held by a lender.

Bob Lawless is more skeptical: his problem is that the homeowner has very little incentive to maximize the sale price on the property. I have three responses to him:

1) If you're under water on a non-recourse mortgage, you already have no incentive to maximize your sale price. This changes nothing.
2) The homeowner does share in the upside, so long as the house is sold for more than it was bought for.
3)In any event, the whole point of this plan is to prevent people from putting their houses on the market in the first place, and rather to find a way to help them to stay in their houses.

I reckon this plan is definitely worth a try. If it catches on, it could be very helpful indeed. And the great thing about it is that it can all be done unilaterally: there doesn't need to be any legislation first.

Would You Like Fries With that Bailout?

(Mortgage Insider) On Wednesday, the Office of Thrift Supervision (OTS) unveiled a plan to help mortgage borrowers in trouble. The government agency urged federal savings and loan lenders under its authority to refinance loans by reducing mortgage balances to the current market value of the property.

The twist on this proposal is that lenders aren’t being asked to forgive the difference between the old mortgage and a home’s current value. Instead, the OTS is encouraging lenders to issue a “negative amoritization certificate” or warrant for the deficiency balance. If the home is sold at a later date and then regains its value, lenders would recoup the money.

As an example, if a home has a $350,000 mortgage but the market value is $300,000, the lender could refinance the home at $300,000 and issue a $50,000 warrant for the balance. If the house sells in the future and the value has gone up, the lender gets some or all of the money back. If the house is worth more than what’s owed, they could charge interest and anything left over goes back to the homeowner. The fact that the warrants could be publicly traded could make this attractive, given Wall Street’s love of financial wizardry.

Although the plan wouldn’t require any legislation it’s clear that participation would be voluntary. Given that some markets are in the midst of a price free-fall, it seems unlikely that lenders would participate in the most over-valued markets MSAs, the areas that need the most help.

So what’s the impact? On the scale of ideas we’ve heard floated it’s relatively benign. It’s an effort to prevent foreclosures while minimizing the hit lenders might take, without socking it to the taxpayer. Compared to freezing rates, it’s an improvement. At least the investor who bought the security and is anticipating an increased payment stream from the soon-to-adjust ARM isn’t getting blind-sided. In the short-term, no one is getting bulldozed because of government intervention. But it’s hard to envision it having much impact.

Looking at different borrower scenarios helps to identify what value if any comes from this program. Keep in mind, that any loan modification or workout only makes sense if the borrower has the ability to make the payments going forward.

Borrower A – currently paying on-time with a fixed rate. No motive for the lender to refinance at market value and issue a warrant.

Borrower B – currently paying on-time with an ARM. If the borrower can’t afford the payment increase, this program would help, but the borrower is probably a better candidate for a rate freeze. Why take the writedown if you don’t have to?

Borrower C – currently delinquent and holding a fixed rate. This borrower would get some relief if the reduction in principle balance would make the payment manageable. Ironically, it doesn’t appear the OTS developed this program with the fixed rate borrower in mind, although there are no limitations on the type of loan a borrower holds. The conundrum is that while the principle balance is being reduced, the deficiency balance for the late payments on the current mortgage would likely have to be recast into the new mortgage, thus increasing the principle balance or the size of the warrant. Then again, I suppose it doesn’t really make a difference right? What’s another $15,000-$20,000 in principle balance anyway.

Borrower D – currently delinquent holding an ARM. This borrower needs the most help but is probably the one who never should’ve taken out the loan in the first place. Unfortunately, if they are behind today, they won’t be able to afford the payment when the rate increases. Thus, lowering the principle balance won’t save them from foreclosure.

However, this program could, in a relatively short period of time lead to the supersize bailout, (a.k.a. “would you like fries with your mortgage intervention program") by freezing rates, lowering the principle balance and issuing a warrant. The ultimate mortgage combo.

Don’t be surprised if this becomes part of the next major government proposal.

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