Saturday, December 20, 2008

A Plan to Break the Back of the Financial Crisis, And Strengthen the Housing Finance System

By Jack Guttentag and Igor Roitburg

The main objective of our proposal is to break the back of the financial crisis by sharply reducing mortgage foreclosures, while liquefying a major part of the existing mortgage stock. A second purpose is to provide the foundation for a more stable housing finance system in the future.


Requirements of a Successful Program

The root source of the financial crisis is the vicious cycle of declining home prices and foreclosures. The way to break that cycle is for Government to encourage the modification of mortgage contracts in ways that enable borrowers in distress to return to good standing and stay there. The private sector by itself can’t do enough modifications, of types that will not lead to re-defaults, to make a material difference.

Our plan does the following:

Eliminates negative equity on all modified loans. Among other things, negative equity is implicated in high re-default rates on modified loans.

Provides Incentives For Servicers/Investors to Write-down Loan Balances. The Government shares part of the write-down with the investor, and back-stops payment insurance on modified loans.

Provides a Mechanism for Government to Be Repaid: Because the initial cost of the program is high, it is important that Government recover its outlays in the future when the economy has turned around and the Federal deficit has to be reduced.

Re-underwrites Modified Loans: To keep re-default rates down and provide a basis for establishing insurance premiums, modified loans should be re-underwritten.

Provides Improved Program Administration: To eliminate logjams in processing modifications, a major part of the workload should be shifted from understaffed mortgage servicers to mortgage insurers with excess capacity.

Eligibility Requirements For Loan Modifications

To be eligible for the program, borrowers must occupy their home as their principal residence, and their mortgage must be in default. The default requirement is very unfair to borrowers who exercised prudence and foresight in selecting a mortgage they could manage, and it is unfair to borrowers who have managed to stay current on their payments at substantial pain and cost. It also places the Government in the uncomfortable position of encouraging borrowers to default so that they can take advantage of the program. And, of course, innocent taxpayers get stuck with the bill.

These are unfortunate but unavoidable by-products of an effective program to curb foreclosures, which is necessary to stop the decline in home prices, which is necessary to terminate the financial crisis. Inequities stemming from the crisis and associated recession, which include widespread unemployment and enormous losses of wealth, swamp the inequities stemming from programs designed to break the crisis.

Need to Eliminate Negative Equity on Modified Loans

Negative equity is when the loan amount exceeds the value of the property; it is what borrowers term being "upside down." It needs to be eliminated on modified loans to avoid a high incidence of re-defaults, to make the loans insurable, and to restore mobility to upside-down borrowers.

There is a lot of wishful thinking that so long as borrowers can afford the monthly mortgage payment, they will continue to pay, disregarding their negative equity. That may have been true historically when negative equity was unusual and when it did arise, it was small. There is mounting evidence, however, that substantial negative equity – say loan balances 20% or more above property value -- causes some borrowers to default who can otherwise afford their payments.

Further, negative equity has enormous social costs above and beyond the impact on foreclosures. Borrowers with negative equity have no mobility; they can’t move to where the jobs are without defaulting on their mortgage. Members of the armed forces are a particular source of concern -- if they have negative equity and are ordered to a new base, they are forced to default.

Borrowers with negative equity also are likely to cut their discretionary spending. In an economy entering a recession, this is bad news.

While negative equity is a millstone around the neck of the economy, getting servicing agents and the investors they represent to implement them, is a major challenge.

Reluctance of Loan Servicers to Write-Down Balances

With a few exceptions, servicing agents view balance reductions as a last resort. One reason could be that a reduction in the balance reduces servicing fees, whereas a reduction in the interest rate or extension of the term, do not. (Servicing fees are expressed as a percent of the loan balance). Our impression, however, is that this is probably less important than the burden of having to justify balance reductions to investors. Servicers are contractually bound to select the modification that is least costly to investors, and in the short-term, balance reductions are the most costly.

On loans paid off before term, which almost all are, a modification aimed at reducing the payment to some target amount costs an investor less if done through a term extension or a rate reduction rather than a balance reduction. (See note). In addition, rate reductions can be temporary, which is not possible with balance reductions.

Note: Assume the loan has a balance of $100,000 at 6% with 360 months remaining and a payment of $599.56. If an affordable payment is 20% lower at $479.65, the balance must be reduced by 20% to $80,000, or the rate must be reduced to 4.0385%. If the loan runs for 5 years, the balance collected by the investor will be $74,443 in the first case, $90,503 in the second. The cost of the rate reduction will be $16,061 less than the cost of the balance reduction. The cost difference disappears only if the loan runs to term.

Term extensions are also less costly to the investor, but on 30-year loans that are only a few years old, the payment can’t be reduced very much. Term extensions are an effective way of reducing the payment on 10 and 15-year mortgages, but these comprise a very small .share of loans in distress.

Balance reductions do have one major advantage for investors: they reduce negative equity, which reduces the re-default rate on loans that are modified. A balance reduction can be justified to the investor, even though the required rate reduction would have a lower initial cost, if the balance reduction had a materially lower probability of re-default.

Until recently, data were not available to support that claim, but that is gradually changing. Some of this evidence is reported by Kate Berry in National Mortgage News, December 1, 2008. For example, she cites data provided by Rod Dubitsky of Credit Suisse, who found that the re-default rate on modifications that reduced the loan balance was about half that of other modifications.

This, along with the special inducements to reduce balances described below, should be more than enough to make balance reductions a no-brainer for investors.

Restoring Confidence and Marketability

A major feature of the financial crisis is the general loss of confidence in the quality of financial assets other than those guaranteed by the Federal Government. With the loss of confidence has come the loss of ascertainable values and marketability. This process began in the home mortgage market, and its reversal ought to begin there as well.

Under our program, modified loans will acquire an ascertainable value and become marketable by eliminating the risk of re-default to the investor. To accomplish this, modified loans: a) Will be written down to 90% of the current market value of the property; b) Will be re-underwritten by a private mortgage insurer (PMI); and c) will carry payment insurance issued by the PMI.

Government will support the process in two ways. First, it will make a contribution to the balance write-downs equal to 10% of the current market value of the properties (See note). A significant part (if not all) of the write-down cost will be recoverable from borrowers in the future, as discussed below.

Note: For example, if the loan balance is $100,000 and current property value is $80,000, the balance must be written down to 90% of $80,000, or $72,000, of which government will contribute 10% of $80,000 or $8,000.

If a loan has a second lien, the Government advance will cover 12%, with the investor responsible for removing the second lien. If a loan has an existing mortgage insurance policy, the investor and the PMI will negotiate the share of the write-down assumed by each.

Second, Government will provide backup reinsurance on the modified mortgages insured by PMIs, as described below.

Mortgage Payment Insurance on Modified Loans

The mortgage payment insurance proposed here (MPI) differs from traditional mortgage insurance (TMI) in protecting against cash flow interruptions as well as losses from foreclosure. Under MPI, a private mortgage insurer (PMI) guarantees that investors will continue to receive scheduled payments of interest and principal on time following a borrower default. If the default is not corrected, payments from the insurer continue until the foreclosure process is completed. At that point the investor is reimbursed for the unpaid balance plus foreclosure cost.

The MPI proposed here has 100% coverage, and will carry full faith and credit reinsurance by the Government National Mortgage Insurance (GNMA), which will assume responsibility for payments in the event of a PMI failure. To encourage PMIs not to be overly restrictive in their underwriting, for three years the Government will absorb the first 10% of loss on all claims. The PMI’s liability would be 40% of the loss, after the 10% paid by the Government. Government will also take the last 50% of loss. GNMA will receive a reinsurance premium of 20 basis points, most of which should turn out to be profit.

Repayment of Government Contributions to Balance Write-Downs

We have not estimated the Government outlays that will be required to support balance write-downs, but they will be large. In a contracting economy, there is no danger of inflation from these and the other Government bail-out programs. When the economy recovers, however, the enormous amount of liquidity injected into the financial system will become an inflationary danger, which is why it is imperative that as much as possible of these outlays have a return address.

The Government’s contributions to balanced write-downs will be secured by a second lien owned entirely by the Government. The lien will be non-interest-bearing for the first 5 years, after which it will accrue interest at a rate set by the Government. The lien must be repaid on sale of the property, or after 10 years if the property has not been sold. The payment will be for the amount owed, or 50% of the appreciation of the property from the value stipulated in the MPI policy, whichever is less.

Interest Rates on Modified Loans

The interest rate on modified loans will be the lower of a) the existing rate; b) the rate that will make the new payment including the insurance premium equal to the existing payment; c) the rate that will make the new payment plus taxes, insurance and other debt service 38% of the borrower’s income; and d) the 10-year Treasury constant maturity rate plus 1%.

Role of Private Mortgage Insurers

MPI offered by PMIs at market terms is a logical and extremely economical extension of traditional mortgage insurance (TMI). While MPI provides much more valuable protection to investors than TMI, in most cases it will cost insurers less, and therefore should not result in higher insurance premiums. See Appendix Note A on The Cost of MPI.

PMIs play a central role in the program, since they will be responsible for:

*Determining the new interest rate, following the rules stipulated above.

*Establishing actuarially-based insurance premiums to be paid by the borrower.

*Assuring that the borrower has provided informed consent to the transaction.

*Obtaining the appraisal upon which the new loan balance is based.

Parameter Values

The parameter values cited above are subject to modification. They are as follows:


Maximum New Balance as Percent of Current Market Value: 90%

Government Write-Down as Percent of Current Market Value: 10%; With Second Lien: 12%

Borrower Repayment:

Interest Rate on Lien (1st 5 Years): 0%

Interest Rate on Lien (After 5 Years): TBD

Percent of Appreciation: 50%

Period Until Repayment Is Due: 10 Yrs

Government’s Reinsurance Liability

First Loss Position: 10%

Period 3 Yrs

Last Loss Position 50%

Modified Interest Rate

Maximum Expense to Income Ratio: 38%

Spread Over Treasury 10-Year Rate 1%

Summary of Obligations and Benefits For Major Participants





Write down balance of loan to 90% of current market value of home

Government pays for part of write-down (10% of current market value of home)

Reduce interest rate on loan to 10-yr Treasury plus 1%

Loan returned to good standing

Guarantee of timely receipt of all mortgage payments plus repayment of principal, backed by Government

Resumption of servicing fees


Pay MPI insurance premium

Loan balance reduced to 90% of current market value of home

Give Government second lien equal to Government write-down contribution; agree to repay in future

Loan rate reduced, payments made affordable

Demonstrate ability to make reduced payments

Mortgage Insurer

Review and underwrite each loan

Receive MPI premiums

Administer MPI program

New and profitable line of business


Pay investors 10% of current market value

Receive second lien equal to write-down contribution

Reinsure payment insurance

Receive reinsurance premium

1 comment:

Life Insurance Canada said...

Interesting thoughts (especially those about mortgage insurers :) But I think it's a bit too late, at least for the United States. The confidence was definitely lost. On the other hand it can be good for the future. People learned the their lesson. Real estate is not 100% safe investment and sometimes it can end disastrously. So I think there will be much bigger demand for some protection in the near future...
Take care