A(nother) Wide-Scale Mortgage Principal Balance Reduction Initiative Will Not Happen
Volumes of research have appeared over the past six months about loan modifications, why they do not work, and what makes for the optimal solution. They all agree that permanently waiving principal is the key to a successful mod. The chances of an effective wide-scale principal balance initiative are slim to none.
And I am not talking about some sort of an earn out program whereby if borrowers make three to five years of payments on time, they get a principal balance reduction. This sort of thing is not a true principal balance reduction program like the long-forgotten FHA Hope-for-Homeowners (H4H) that sends the borrower away from day one fully de-levered with a 45% back-end DTI their principal balance reduction in hand. Anything short, and more mods will continue to fail.
All of this is an exercise in futility. They are all looking in the wrong place. It is obvious that if you throw $100k in equity at a homeowner who is in default, it changes things for some. I wrote an essay on this in early 2008 when everybody still believed the crisis was contained to Subprime. Back then I was in favor of a national principal balance reduction initiative that dealt with first and second mortgages as a way to force-delever American households and slow the crash in housing in order to prevent a massive consumer led recession/depression.
In it, I hypothesized that that a targeted $2 trillion to buy down mortgage balances and then another trillion in gov’t tax breaks for those that didn’t not need help with their mortgage in order to prevent blow-back and further stimulate the economy would stop what I saw at the time to be a collapse of most of the nation’s banks if not the financial system itself. I was early. Now my $3 trillion looks like a cheap fix. But at this stage of the game, principal balance reductions are 1.5 years and 10 stimulus programs late and $3 trillion short.
Quit wasting your energy – a wide-scale principal balance reduction program is not likely. I do not think it should happen. It is questionable whether they would even make much of a difference. It surely would not be worth the 50 gallon drum of worms it would open. Reductions would only clinch the deal for those on the borderline who are defaulting purely because it makes for a good investment to exercise their option to default based upon equity.
The moral hazard this would create is huge – default rates would shoot through the roof, especially from those premeditated defaulters that can really afford to pay but just want a gov’t hand out. Or, those simply looking for an exotic rate reduction refi who can’t qualify for or benefit from today’s vanilla 30-year fixed rates loans…remember, mortgage mods are nothing more than gov’t sponsored 5-year, interest only, teaser rate, balloon exotic loans created to replace the exotic loans of yesteryear.
If is important to note, however, that some banks are offering principal reductions to certain borrowers such as Wells Fargo on select Pay Option ARM borrowers. But this is the exception and not the rule and typically reserved for loans wholly owned by the financial institution.
Bottom line.– a gov’t sponsored, wide scale principal balance reduction initiative that gives $10s or hundreds of billions to the minority 15% who are distressed and leaves the 85% who pay on time each month in the lurch would be an unmitigated disaster across many levels.
Additionally, political will is not on the side of carpet bombing stimulus plans any longer because of the blow-back and because the Administration wants to reserve what political capital they have left for the big tasks at hand, such as socialized health care. In fact, the Administration’s latest push is for a targeted jobs package, not another $800 billion across the board handout. There is just not enough of anything left for something as large and controversial as a wide-scale principal balance reduction initiative.
$300 Billion Already Committed to Principal Balance Reductions
But beyond all of this, we already have a massive principal balance reduction program in place. It’s called Hope-for-Homeowners — or the H4H — which calls for HUD to insure up to $300 billion in refi’s if the lender reduces the principal balance and the borrower qualifies under very lose standards. In fact, the guidelines were just made easier late last year. I am not necessarily a Chris Dodd fan, but this program was years ahead of its time and he knew it back in 2008.Opportunity funds that even know a little about the mortgage banking universe, warehouse lending and Ginnie Mae II securitizations could put up triple digit annualized returns — while taking virtually no credit risk and looking like heroes for coming to the aid of the housing market — utilizing the H4H in the way I believe it was intended, which is not the way anybody is working the opportunity, yet. That is all I am going to give you in a public forum.
Negative-Equity Alone is not the Primary Default Driver
For the majority, it is not about having an equity position that is 1% positive or 20% negative. It is about being over-levered in addition to being underwater relative to rents, which have consistently fallen for two years.The HAMP chart in my 1-19 research note below says it all – it also goes to show how aggressive lending really was during the bubble years. What everybody glosses right over is the fact that AFTER a HAMP mod, the median borrower has a total debt-to-income ratio of 55.1%, not the 31% that is promoted by the program. This single data point is the primary reason most mods fail, not the negative-equity on it’s own.
As a former career mortgage banker, I can guaranty that if DTI’s were brought down to around 40% or below that the re-default rate would fall sharply regardless of the equity position because it would be cheaper to stay than move and rent. And even if it was slightly more expensive to stay vs rent, most would still stay for a variety of reasons.
The most important factor at 40% DTI is that borrowers are much less at risk of mortgage default because they have disposable income each month to save, shop and live their lives relatively normally during their years of de-leveraging. For example, somebody earning $10k a month with a total back-end DTI of 40% and a CLTV of 120% is a much better credit risk than somebody earning the same with a back-end DTI of 60% and a CLTV of 99%.
At the present 55.1% after mod back-end DTI, modified borrowers are debt slaves. It’s that simple. A HAMP 2% rate is not aggressive enough based upon the data released by the program. The median HAMP borrower remains far too over-levered post-mod. The sad part is that most delinquent borrowers could be offered a 0% rate and they probably would still be over-levered based upon time-tested 28/36 mortgage banking DTI’s. This is why mortgage mods by and large are destined to fail.
Embracing HAFA – (Home Affordable Foreclosure Alternatives)
It is time to move on. The best solution going forward is for the banks to fully embrace Treasury’s HAFA (short sales and DIL’s) program, begin to foreclose in earnest like they started to in 2008, and get these properties into the hands of new owners. We know there is huge demand for distressed real estate from investors and those that really can afford to own a home and prices in the hardest hit regions have stabilized somewhat (at least temporarily), so the timing is good. Even though HAFA involves removing borrowers from their homes — because it is not done through the process of foreclosure — it technically conforms to present day anti-foreclosure political will.
There is a lot of excitement around this one. The initial reaction from the lenders I talk to is very positive — if forced to chose, they much rather have a short sale or DIL than a foreclosure because loss severities are much less for obvious reasons. HAFA is very well thought out — other than some tweaking that needs to be done surrounding second mortgages — and some large banks are investing a lot of energy creating detailed policy & procedure and best practices in addition to training and redeploying HAMP modification staff in order to fulfill the expected demand. Before too long, I expect the HAFA infrastructure and developed best practices to be used for non-GSE loans as well just like we saw with HAMP.
Homeowners are not being done any favors through loan mods — the distressed homeowner will be in a better position renting a property that they can really afford instead of being saddled to hundreds of thousands in debt that chews up the majority of their gross income every month. Obviously, this will be painful on many financial institutions but the fact is they can’t kick the can forever. And the longer they kick it, the greater the losses will be when the chicken finally comes home to roost.
The unintended consequences of HAMP was creating a lack of distress inventory, which is most in demand. Without REO, which made up a large percentage of total sales last year, the depressed rate of existing home sales in 2009 was as good as it gets for a lot of years. HAFA is exactly what is needed to keep sales counts from tumbling in 2010. The only negative is that because DIL’s are REO and short sales considered ‘distressed’, there will be negative housing implications from significantly increased distressed sales as a percentage of total sales.
This is why I believe that 2010 kicks off a paradigm shift from pretend and extend to the first year of a multi-year drive to finally de-lever through increased asset liquidations spearheaded by the HAFA initiative. Over a lot of years, this is exactly what is need to essentially ‘reset’ the housing market and is where my research centers this year.
Excerpt from my 1-18-2010 Mortgage Pages research note on the HAMP DTI Topic
A Making Home Affordable program update through Dec 09 came out last week (attached). The update was given kudos by many as a sign HAMP is starting to get on track due to the large number of mods that went temp to perm over the past couple of months. Others slammed the low overall temp to perm pull-through at less than 10%.
I am not going to do either, rather point out a single page in the report that highlights exactly why so many will ultimately fail and there is no place for defaults and foreclosures to go in 2010 but straight up. Within the report, there are a series of charts. The ones pertaining to house prices, sales and inventory and mortgage rates metrics…disregard them. This is because when the gov’t seizes control of the supply and demand fundamentals temporarily through artificially low rates and default and foreclosure moratoria, old-school headline metrics such as ‘months supply’ don’t mean much.
1) The Back-End Debt-to-Income Ratio Nightmare
Everybody loves to talk up the 31% HAMP DTI that is billed as the differentiating factor between HAMP and it’s predecessors. But who cares about the Front-End DTI when no concern is given to the total DTI.
As shown in the chart below, the MEDIAN post-mod Back-End DTI is a whopping 55.1%. The pre-mod Back-End DTI was a nose-bleed 72.2%. Now, that is production oriented underwriting! I have always said “mods make homeowners underwater, over-levered renters unable to sell, re-buy, refi, save or shop”. This chart proves it.
A household with a post-mod Back-End DTI of 55.1% remains in serious trouble. Remember, negative equity alone is not the primary driver to default — being in an over-leveraged household balance sheet position with negative equity is. When 55.1% of your gross income is going out to debt listed on your credit report — not including income taxes, household expenses (food, auto insurance, utilities, gas etc) and all other expenses of life — you are extremely over-levered.
My guess that the majority of mods with a total Back-End DTI of over 40% will ultimately fail. And a Back-End DTI over 40% likely represents the majority of all mods given the median is 55.1%. High Back-End DTI’s are also why at the end of the day, defaults and foreclosures will be much higher than anybody’s present estimates, as I outlined in my 12-6-09 report – “Millions More at Risk of Default Than Most Think”.