Struggling borrowers get fresh start under new plan
Part 5: Fixing the housing finance system
By Jack Guttentag, Monday, June 2, 2008.(This is Part 5 of a five-part series. Read Part 1, "Lenders wise to beef up default-risk reserves"; Part 2, "Borrowers, insurers would save with new mortgage insurance"; Part 3, "Mortgage insurance cheaper under new plan"; and Part 4, "Help from feds not a bailout.")
This series of articles introduced a new type of mortgage insurance called mortgage payment insurance, or MPI. Under MPI, insurers guarantee timely receipt of the mortgage payments after the borrower defaults, as well as protection against loss if the loan goes to foreclosure.
Despite the fact that the insurer under MPI assumes virtually the entire risk of default, because MPI also reduces the rate on high-risk loans, MPI on such loans will cost the insurer less than traditional mortgage insurance (TMI).
This article describes how MPI could be used right now to reduce the number of foreclosures, and reduce losses on the foreclosures that occur.
Loans in Default That Carry TMI: We estimate that there are about 600,000 loans now in default that carry TMI. Case-by-case efforts to modify these loans will make only a tiny dent in the total. There are major impediments to such modifications, and even when these impediments are removed, the process is costly and time-consuming. MPI makes possible wholesale modifications covering large numbers of loans that are in the interest of all parties -- insurers, investors, borrowers and servicers.
If loans in default carry TMI, the insurer is already on the hook for the coming loss, up to the cap on the policy. If the net proceeds from sale of the property do not cover the unpaid balance including accrued interest plus foreclosure expenses, the investor is protected up to the cap amount for any deficiency.
In more normal conditions, deficiencies in coverage seldom arise. In the current market, however, house-price depreciation has made deficiencies the rule rather than the exception. Under these circumstances, the deal using MPI shown below will make both the insurer and the investor better off. In the process, a significant number of borrowers will be saved from foreclosure.
Existing TMI policies are converted to MPI at the currently prevailing prime interest rate, provided that the monthly mortgage payment declines by 10 percent or more.
The major benefit arises when the payment reduction resulting from the rate reduction allows the borrower to return to good standing. All three parties are better off. The downside to the investor is that some of these loans may cure themselves without the investor having to reduce the interest rate. Losses to the investor from this source, however, would be much smaller than the gains from loans that return to good standing that would not have cured themselves.
Loan servicers have a self-interest in making the package deal described above because the resumption of payments under MPI also means a resumption of servicing fees. When borrowers stop paying, servicing fees stop. As loans are placed in good standing under MPI, servicing fees resume.
Loans in Default That Do Not Have TMI: When loans in default do not carry PMI, the investors are on the hook for the entire loss. The insurer will not assume the risk except as a new loan that meets its underwriting requirements, and carrying an MPI insurance premium scaled to the risk. These deals must be done one at a time.
To meet its requirements as an insurable loan, the insurer will require the investor to write down the loan balance to 90 percent or 95 percent of current property value, and reduce the interest rate to the prime rate. If there is a second mortgage, the investor will have to negotiate a payoff with the second mortgage lender.
The investor would take a loss on the modification, but it would be far smaller than the loss that would have resulted from foreclosure of the original loan. The investor might also receive an equity certificate equal to the write-down of the balance (or balances, if there is a second lien), which would entitle it to a share of the future appreciation in the value of the house.
The borrower gets a new start with 5 percent or 10 percent equity, no unpaid interest, and a reduced payment based on the lower rate. Because the payment reduction will be partly offset by a new mortgage insurance premium, this plan will work best with higher-rate mortgages.
This application of MPI to loans that do not now have TMI is very similar to the proposed "FHA Housing Stabilization and Homeownership Retention Act of 2008" (HR 5830), but there are some major differences that I don't have space to describe. Interested readers can get a longer paper that includes it by writing me.
The proposals for fixing the system were developed with Igor Roitburg, who has a patent pending for MPI in which I have an interest.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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Submitted by chis eliopoulos on June 2, 2008 - 7:37am.
This is nothing more than more complication in an already complicated process.
There are so many guards in place to protect lenders, yet nothing has worked to protect them from their greed.
When markets are lapsing (for whatever reason) it is extremely arrogant that the whole industry has to be concerned about the losses of the lenders. All players take a hit including the lenders. Historically lenders have found help from the feds , who always bailed them out (at our expense).
I say, forget the lenders, their interests, and losses. In my book they can get lost and never resurface again. There always will be participants in a booming market to provide finanancing.
The last two real estate crashes (1990s and now) were accelerated in part from the irresponsible lending practices. Why would consumers foot an additional bill like the exorbitant cost of PMI to protect entities that profit from them?
Lenders currently are sitting on huge inventories of properties that they have repossessed. Yet the sale of these properties is laborious because one has to meet their lengthy paperwork (cover my ass) requirements. The above practice accelerates the depression of the market. Again, I don't think there should be any additional protection for them and there should be conscious effort to get the lenders out of the real estate practice and find other ways to finance real estate in the future, from entities that are willing to take profits and losses like the rest of the participants.
Submitted by Jeri Creson on June 2, 2008 - 10:07am.
While I'm not in favor, necessarily of "bailing out" irresponsible lenders, I recognize the realities that big business holds great power to do incredible damage to the little guy at will. We can always count on big business and large lenders to protect their assets. As they should. They are not charity organizations. Their purpose is to seek a profit. We have learned that the nature of man is to seek that profit at the expense of all others.
By providing a less destructive path that is more feasible, and more profitable to the lenders, we encourage them to take that path, rather than leave a wake of destruction behind them. A shared equity situation is a good solution. The borrowers are not innocent bystanders. In many cases they were deceived. In many others, however, foolhardy greed and illogical decision making entered the picture on the consumer side as well. Properties are not ATM's, and the average consumer has no business playing Las Vegas craps with their equity. A voice of reason came too late on both sides of the equation.
Now, it sounds reasonable to me that both sides seek a solution. For the consumer, the chance to keep one's home. For the bank, who can afford to modify the loan now, and gamble on equity later - far better than the consumer can - it seems a reasonable option. So the bank and consumer become "co-investors" in the property, each sharing in the potential future gains. And today, we rest, and pay our (affordable)mortgages.