The head of the Federal Reserve is calling for more modifications involving a write down of principal on mortgages for borrowers with negative equity. He explained how investors may actually come out ahead by allowing such modifications when compared to foreclosures.
More than 20 percent of the 3.6 million subprime adjustable-rate mortgages outstanding at the end of 2007 were seriously delinquent, Federal Reserve Chairman Ben Bernanke told the Independent Community Bankers Association today. Subprime fixed-rate loans had a delinquency rate of 8 percent while Alt-A ARMs had a 6 percent rate.
About 1.5 million foreclosures were initiated during 2007, up from an average of less than 1 million in 2005 and 2006, according to a transcript of his prepared remarks at ICBA's annual conference in Orlando, Fla. Over half of last year's foreclosure filings were on subprime loans.
ARM delinquency has been linked to higher loan-to-values, with more than 40 percent of subprime originations in 2006 having an LTV in excess of 90 percent, "considerably higher" than in prior years. A combination of weakening real estate markets, risk layering and negatively amortizing loans exacerbated the problem.
As equity continues to decrease and resets accelerate -- 1.5 million resets are estimated for this year -- delinquencies and foreclosures will likely continue to rise. With the contraction in subprime lending, refinances are not an option for most borrowers who face resets.
While the FHASecure plan and the temporary increase the to maximum loan amount that can be insured by the Federal Housing Administration will provide some relief, not all borrowers will qualify or be able to convince second lien holders to subordinate. State-funded refinance programs also tend to have tight eligibility criteria and have yet to be utilized widely.
Loss mitigation by servicers needs to take into consideration the net present value of the modified payment stream and compare it with the net present value of a foreclosed loan. Missed mortgage payments, taxes, legal and administrative fees, maintenance fees and real estate commissions all need to be factored in to the foreclosure payment stream. In addition, the likely reduction in value associated with repossessed, vacant properties must also be considered.
Bernanke cited a study of fourth quarter 2007 subprime foreclosures that indicated losses exceeded half of the principle balance. As the amount of time involved in the foreclosure process is expected to increase, losses could increase further.
"The magnitude of, and uncertainty about, expected losses in a foreclosure suggest considerable scope for negotiating a mutually beneficial outcome if the borrower wants to stay in the home," he said. "Unfortunately, even though workouts may often be the best economic alternative, mortgage securitization and the constraints faced by servicers may make such workouts less likely."
Because servicers are limited by the type and scope of modifications that are explicitly permitted in trusts, they might not pursue workout options that are in the best collective interests of investors and borrowers. But recent data indicate subprime workouts have increased to 300,000 in the fourth quarter from around 250,000 in the third quarter, while prime workouts have risen to 175,000 from 150,000.
With modifications, lenders prefer to write down the interest over writing down principal because they may feel pressure to write down principal again if home prices fall again, and because they won't participate in any appreciation if prices rise.
"Both types of modification involve a concession of payments, are susceptible to additional pressures to write down again, and result in the same payments to the lender if the mortgage pays to maturity," the Fed chief explained. "The fact that most mortgages terminate before maturity either by prepayment or default may favor an interest rate reduction. However, as I have noted, when the mortgage is 'under water', a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure."
Bernanke suggested investors should allow servicers to write down balances enough to enable borrowers to refinance. Such a write down might include a shared interest in future appreciation.
But he acknowledged that investors of different tranches of mortgage-backed securities might benefit differently.
"The fact that many troubled borrowers have little or no equity suggests that greater use of principal writedowns or short payoffs, perhaps with shared appreciation features, would be in the best interest of both borrowers and lenders," Bernanke concluded. "This approach would be facilitated by allowing the FHA the flexibility to offer refinancing products to more borrowers."