Abstract
The note delves on the U.S. housing market outlook, the potential benefits of mitigating distressed sales household deleveraging, and the recovery. Policies to facilitate labor market adjustment to reduce the large employment volatility without affecting efficient labor allocation could prevent problems. U.S. firms are hoarding money but it is likely to be spent to boost firms’ capital expenditure, rather than kept as precautionary balances. The note discusses commodity price shocks affecting Treasury inflation protected securities (TIPS), budget institutions for federal fiscal consolidation, and mortgage delinquencies in the United States.
IX. The Challenge of Dealing with Mortgage Delinquencies1
Foreclosure mitigation policies, which have had limited success so far, could have a measurable impact on economic activity by avoiding undershooting of house prices. In order to increase sustainable modifications, principal writedowns could be pushed harder in the Home Affordable Modification Program (HAMP). There is already a Principal Reduction Alternative (PRA) program under HAMP, but it could be aimed at bringing loan-to-value (LTV) ratios below 100 percent and requiring that back-end debt-to-income (DTI) ratios are taken into consideration. In addition, the government-sponsored enterprises could be encouraged to participate in the HAMP-PRA program. Also, mortgages on principal residences could also be subject to court-ordered modifications (“crammed down”) in Chapter 13 bankruptcy proceedings—a long-standing Fund recommendation. Additional incentives could also be provided for deed in lieu and short sales.
A. introduction
6. The design and implementation of mortgage modification programs have been daunting tasks. There are coordination problems among the various players in the mortgage industry, and parties may have competing objectives. In addition, the initial design for most programs focused on affordability issues, rather than on the needs of the unemployed and underwater homeowners (the biggest proportion of borrowers in default at the moment). In addition, given the emphasis on minimizing moral hazard, most policies included stringent participation requirements. Given these factors, participation has been limited with only 610,000 permanent modifications taking place compared to a target of 3–4 million by 2012 under the HAMP.2 This small success rate partly reflects high re-default rates on modified loans given the limited consideration to back-end DTI ratios as well as (i) a stubbornly high unemployment rate and (ii) homeowners’ negative equity.3 So far, the programs have been underutilized; out of the $45.6 billion committed for housing under the Trouble Asset Relief Program (TARP), only $1.4 billion has been disbursed, with the Congressional Budget Office (2011) estimating that the eventual cost would amount to $13 billion.4
B. Current Federal Foreclosure Mitigation Efforts
7. The Administration has adopted a multi-faceted approach to tackle the foreclosure epidemic. Most programs (including HAMP) re-amortize mortgage payments so that the front-end DTI ratio decreases to 31 percent (by applying interest rate reduction, term extension and/or principal forbearance), with some programs also targeting underwater homeowners (HAMP-PRA, Federal Housing Administration’s Short Refinance Program (FHASRP) and Hope for Homeowners (H4H)).1 In most cases, monetary incentives are provided to servicers and investors to undertake modifications and/or principal writedowns, since in their absence, servicers often find foreclosures more profitable.2 To tackle the rising unemployment rate, the Administration has also introduced some foreclosure forbearance programs for the unemployed, some in collaboration with states (Box 1 discusses some of these foreclosure mitigation efforts).
8. Several reasons explain the limited participation and success:
Most foreclosure mitigation policies focus on affordability issues. There is a limited array of programs that focus on unemployed and/or underwater borrowers—the largest proportion of delinquent homeowners. In addition, some programs, such as HAMP do not consider back-end DTIs which is rather problematic. With the average back-end DTI on HAMP-modified loans exceeding 62 percent, it is not surprising that re-defaults are considerable. Indeed, there is growing evidence that re-default rates are much lower for modified loans with large declines in principal and interest (Amherst Securities, 2011, Julapa and Lang, 2010, Mayer et al., 2010, OCC, 2011).
Modification Re-default Rate
Citation: IMF Staff Country Reports 2011, 202; 10.5089/9781462317356.002.A009
Sources: Amherst Securities as of May 2011, CoreLogic, and Fund staff calculations.LTV parameters are “tight.” For example, the HAMP-PRA program applies only to loans with LTV ratios above 115 percent, and only lowers the LTV to 105–115 percent, leaving the borrower underwater post-modification. Similarly, even though FHASRP gets LTVs down to 97.75 percent, it allows lenders to maintain a second lien for up to 17.25 percent of the property value, implying that the homeowner could still be 15 percent underwater after the refinancing.
The Government-Sponsored Agencies (GSEs) have not undertaken any principal writedowns. This decision has large effects on outcomes as they control the servicing of almost 60 percent of outstanding U.S. mortgages.
There continues to be loan servicing under-resourcing. Servicers still do not have the capacity or knowledge infrastructure to deal expeditiously with a mounting number of defaults, while fears that modified loans will slip back into delinquency (“redefault”), or that delinquent loans will become current (“self cure”) without loan modifications might discourage them from investing additional resources (Adelino, Gerardi, and Willen, 2009; Das, 2010; Haughwout and Okah, 2009).
All programs face a complex coordination problem among industry participants with potential incentive conflicts, including for second lien mortgages. Servicers, investor/lenders, homeowners and (except for HAMP-PRA) FHA lenders have to coordinate effectively during the modification process. Particularly problematic to all modification efforts have been second lien mortgages that lenders have been reluctant to write off. In addition, in many cases, the servicers do not have an incentive to undertake modifications, since they are fully compensated for all legal costs when a delinquent mortgage enters foreclosure—not when it is modified (Kiff and Klyuev, 2009). In this regard, Agarwal et al. (2011) show that securitized seriously delinquent mortgages are less likely to be modified than are (“portfolio”) loans held on lender balance sheets.
FHASRP requires that the loans are not delinquent which may be binding given that one in eight mortgages is already delinquent or in foreclosure.
C. What More Can be Done?
9. There is no easy solution to the foreclosure problem. In the remaining section, we provide some suggestions (some more radical than others) on other alternative policies that could be enacted to address the foreclosure problem. However, each suggested policy always entails some risks, typically in the form of encouraging moral hazard, assisting undeserving homebuyers and prompting otherwise current borrowers to intentionally default.
Parametric Changes to Existing Programs
10. Programs could tackle negative equity more forcefully and take into account back-end DTIs. The FHASRP program could remove the second lien component that takes the 97.75 percent LTV to as high as 115 percent, while HAMP-PRA could be adjusted so that a borrower does not remain underwater post-modification. Also, the back-end DTI ratio that the FHASRP and H4H refinancing programs have could usefully be applied to the whole HAMP program to minimize re-default risk.
11. Investor/lender house price appreciation sharing (as in H4H) could also be included in all principal writedown options, in order to mitigate moral hazard risk. Such agreements are mentioned in the HAMP-PRA guidelines, but they are not required. Another option would be to impose on homeowners who benefit from principal writedowns a special tax on future appreciation. In addition, the writedown could be phased in over time (for example, one-third each year for three years), which would have the added benefit of incentivizing the homeowner to stay current (Amherst, 2011). Such arrangements would also minimize the risk of having borrowers strategically default, in fear of losing future capital gains.
12. The fiscal cost of scaling up principal writedowns would not be insurmountable. We estimate that in a scenario where all negative equity is written down, the fiscal cost—given the parameters of the current HAMP-PRA—would amount to $130 billion.1 This is an upper bound, corresponding to all eleven million underwater mortgages defaulting, implying that the average cost of foreclosure prevention is around $12,000. We also ignore income considerations in eligibility for the program (for simplicity).
Allowing All Mortgages to be Modified in Bankruptcy Proceedings (“Cram downs”)
13. Under current law, debtors can “cram down” mortgages on vacation homes, investor properties, and multifamily residences in which the owner occupies a unit (White and Zhu, 2009). Cramdowns, however, are not allowed in Chapter 13 Bankruptcy proceedings for single family principal residences. Debtors can also currently modify wholly unsecured second mortgages on principal residences, but the law forbids modifications on first lien mortgages. All other secured claims that are underwater can be “crammed” down to their collateral value, instead. In 2009, Congress rejected a proposal for cramdowns on principal residences (the House passed the bill, but it was defeated in the Senate).
14. Having cramdowns on principal residences could have a central role. This could be a partial solution to the foreclosure crisis that would reduce foreclosures and encourage sustainable modifications, at no fiscal cost to the taxpayers. Cramdowns would not be free for households—they affect one’s credit score and public records—and thus would minimize moral hazard (Levitin, 2009a).1 However, there are some possible drawbacks from having cramdowns including: (i) higher borrowing costs, though the literature has been inconclusive as to whether this effect is large;2 capacity constraints at the court level in dealing with cramdowns; (iii) the risk of giving too much discretion to bankruptcy judges;3 and (iv) the risk of creating legacy problems by changing the rules governing primary residence mortgages after the terms have been agreed upon.
15. Evidence from the farm foreclosure crisis in the 1980s highlights the merits of cramdowns.4 The agricultural lending crisis of the early 1980s was a typical boom-bust scenario with farm land values skyrocketing accompanied by large increases in agricultural debt. Many farmers, just like in today’s crisis, were underwater and in risk of losing their houses. After much deliberation (that lasted nearly 2½ years), Congress established on a trial basis Chapter 12 Bankruptcy in 1986. The legislation—which allowed cramdowns on primary residences of family farms—included a sunset provision to allow time for the study of its impact before it would become permanent; it was extended twice and became permanent in 2005. The law ended up being extremely effective: (i) the cost and availability of credit was essentially unaffected, while (ii) Chapter 12 drove the interested parties to make voluntary private modifications; out of the 30,000 bankruptcy filings that the U.S. General Accounting Office was expecting, only 8,500 were filed in the first two years.
Further Incentives for Short Sales/Deed in Lieu
16. Additional monetary incentives could be provided to servicers/banks so that short sales and deed in lieu are undertaken instead of foreclosures.5 For example, more funds could be given to servicers to cover administrative and processing costs and to investors to allow short sales. As noted in Tsounta (2011), foreclosed properties are usually sold at a discount of up to 27 percent while short sales/deed in lieu—which are often associated with less personal hardship for homeowners and less physical deterioration for the properties—are sold at a much smaller discount.
GSEs and Principal Writedowns
17. Encouraging GSEs to participate in principal write-downs would increase the scope for modifications. Data from the Office of the Comptroller of the Currency and Office of Thrift Supervision (2011) indicate that modifications which significantly reduce monthly principal and interest payments consistently perform better. From a general equilibrium perspective, it would thus be advisable that GSEs also undertake writedowns; in 2010 there have been 29,300 private principal writedowns, of which 13,700 were under HAMP. It is estimated that around 600,000–800,000 of the GSE-guaranteed mortgages are currently underwater and in default.6 While there is the risk that principal writedowns might induce strategic defaults, the large scale of GSE’s operations and thus the large positive externalities from lowering the housing uncertainty induced by the large shadow inventory of houses would likely outweigh these costs, especially taking into account the large fiscal contingent liability by the U.S. Treasury.7 To mitigate the moral hazard risk, writedowns could be complemented with some equity sharing arrangement.
Selected Federal Foreclosure Mitigation Policies
Tackling Underwater Borrowers
Hope for Homeowners (H4H)
Under H4H eligible borrowers may refinance their first-lien mortgage loans into new 30-year or 40-year fixed-rate FHA-insured mortgage loans. The holder of the first-lien mortgage is required to accept writedowns to bring the loan-to-value (LTV) ratio to 96.5 percent. The lender also has to extinguish any junior liens, but in return they get an upfront payment of between 3 and 50 percent of the junior lien unpaid principal balance. After the refinancing, the borrower’s front-end DTI must typically not exceed 31 percent, and the back-end DTI must be less than 43 percent. Servicers can receive a $2,500 up-front incentive payment for each successful H4H refinancing, and lenders who originate H4H refinancings are eligible for incentive payments of up to $1,000 per year (up to three years) for each refinanced loan so long as the loan remains current.
Importantly, to minimize moral hazard, an equity sharing arrangement is included in the event of house price appreciation. If the homeowner sells the house or refinances the new mortgage, the FHA claws back some of the “instant” equity (100 percent in the first year, declining to 50 percent after five years), plus, if the property is sold, 50 percent of any net property value appreciation is taken over by the FHA. Also, borrowers are prohibited from taking out new junior liens during the first five years, except when necessary for property maintenance.
HAMP-Principal Reduction Alternative (HAMP-PRA)
The program applies only to loans with LTVs above 115 percent, and only lowers the LTV to 105–115 percent, leaving the borrower underwater. The mortgage, which has to be delinquent for at least 90 days to be eligible, is then modified so that after the refinancing, the borrower’s front-end DTI must typically not exceed 31 percent; no consideration is given to the back-end DTI ratio. Servicers typically receive $2000 for each modified mortgage, as well as scaled incentives for the writedowns.1 Around 13,700 HAMP modifications involved principal writedowns in 2010.
FHA-Short Refinance Program (FHASRP)
This program converts underwater mortgages that are not FHA-insured into above-water FHA-insured mortgages, provided that at least a 10 percent writedown is undertaken. To be eligible for an FHASRP refinancing the loan must not be delinquent, and the (first lien) LTV ratio must be above 100 percent. The program requires that first-lien investors forgive principal that exceeds 115 percent of the home value in return for a cash payment from the FHA for 97.75 percent of the home value, and maintaining a subordinate second lien for up to 17.25 percent of the value. Existing second-lien holders may receive incentive payments to extinguish their loans in accordance with the same payment schedule used for the HAMP-PRA. After the refinancing, the borrower’s front-end DTI (including payments on the second lien loan) must not exceed 31 percent, and the back-end DTI (including all recurring debt payments) must be less than 50 percent. SIGTARP (2011) reports that FHASRP has not made any incentive payments and no second liens have been extinguished through March 2011.
Tackling the Unemployed
The Home Affordable Unemployment Program (UP) provides unemployed borrowers a temporary forbearance period of up to three months. As of end-March 2011, only 7,400 borrowers were actively participating, despite close to 14 million being unemployed (SIGTARP, 2011).
The Hardest Hit Fund provides targeted aid to families in states hit hard by the economic and housing market downturn (less than $170 million out of the $7.6 billion has been disbursed at end-March, SIGTARP, 2011). The Fund supports state-specific programs designed to meet the distinct challenges struggling homeowners in certain states face—the states were chosen either because they are struggling with unemployment rates at or above the national average or steep home price declines greater than 20 percent since the housing market downturn.
The Emergency Homeowner Loan Program complements the Hardest Hit Fund by serving the remaining states and assists homeowners who have experienced a reduction in income or a medical condition.
Other Programs
The Second Lien Modification Program (2MP) modifies second-lien mortgages when a corresponding first lien is modified under HAMP. In addition, the Home Affordable Foreclosure Alternatives Program (HAFA) encourages short sales and deeds-in-lieu for borrowers for whom HAMP modifications do not work.2 However, neither program has had much of an impact. As of April 2011, only 25,500 homeowners in first-lien HAMP modifications had received assistance through the 2MP and 14,900 had taken advantage of the HAFA. So far, according to SIGTARP (2011), $19 million has been spent on HAFA incentives (out of $4.1 billion allocated). The FHA-HAMP program, which provides assistance to eligible homeowners with FHA-insured mortgages, also had a slow start, with just 2,700 permanent modifications starting until end-April.
References
Adelino, M., K. Gerardi, and P.S. Willen, 2009, “Why Don’t Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures, and Securitization,” Boston Federal Reserve Bank Working Paper 09–04 (July 6).
Agarwal, S., G. Amromin, I. Ben-David, S. Chomsisengphet, and D.D. Evanoff, 2011, “The Role of Securitization in Mortgage Renegotiation,” Charles A. Dice Center for Research in Financial Economics Working Paper 2011–2 (January).
Amherst Securities, 2011, “The Case for Principal Reductions,” Amherst Securities Group LP MBS Strategy Group Mortgage Insight, March 24.
BlackRock, 2009, “Keeping Homeowners in Their Homes: A Proposal for Judicial Mortgage Restructuring,” BlackRock ViewPoints, December.
Congressional Budget Office, 2011, Report on the Troubled Asset Relief Program-March 2011, available at: www.cbo.gov/ftpdocs/121xx/doc12118/03-29-TA RP.pdf.
Corelogic, 2011, Negative Equity Report.
Das, S.R., 2010, “The Principal Principle: Optimal Modification of Distressed Home Loans,” paper presented at the Federal Reserve System and the Federal Deposit Insurance Corporation Conference on Mortgages and the Future of Housing Finance Conference (October 15).
Dubitsky, R., L. Yang, and T. Suehr, 2009, “Bankruptcy Law Reform - A New Tool for Foreclosure Avoidance,” Credit Suisse Fixed Income Research, January 26.
Fitzpatrick, T.F., and J.B. Thomson, 2010, “Stripdowns and Bankruptcy: Lessons from Agricultural Bankruptcy Reform,” Economic Commentary, No. 2010–9, Federal Reserve Bank of Cleveland.
International Monetary Fund, 2011, Global Financial Stability Report, Durable Financial Stability: Getting There from Here, Washington, DC: International Monetary Fund.
Julapa J. and W.W. Lang, 2010. “Strategic Default on First and Second Lien Mortgages During the Financial Crisis,” Working Papers 11–3, Federal Reserve Bank of Philadelphia.
Kiff, J. and V. Klyuev, 2009, “Foreclosure Mitigation Efforts in the United States: Approaches and Challenges,” International Monetary Fund Staff Position Note Available, Washington, DC: International Monetary Fund.
Kittle, D.G., 2007, “Straightening Out the Mortgage Mess: How Can We Protect Home Ownership and Provide Relief to Consumers in Financial Distress?—Part II,” Statement before the United States House of Representatives Committee on Judiciary Subcommittee on Commercial and Administrative Law, October 30.
Levitin, A.J., 2009a, “Resolving the Foreclosure Crisis: Modification of Mortgages in Bankruptcy,” Wisconsin Law Review, p. 565.
Levitin, A.J., 2009b, “Home Foreclosures: Will Voluntary Modification Help Families Save Their Homes? Part II?” Written Testimony before the U.S. House of Representatives Committee on Judiciary Subcommittee on Commercial and Administrative Law.
Levitin, A.J., and J. Goodman, 2008. “The Effect of Bankruptcy Strip-Down on Mortgage Markets,” Georgetown University Law Center Business, Economics and Regulatory Policy Working Paper Series, Research Paper No. 1087816.
Levitin, A.J., and T. Twomey, 2011, “Mortgage Servicing,” Georgetown Public Law and Legal Theory Research Paper No. 11–09.
Mayer, C., E. Morrison, T. Piskorski and A. Gupta, 2010, “Mortgage Modification and Strategic Default: Evidence from a Legal Settlement with Countrywide,” Columbia University Business and Law Schools, July 20.
Office of the Comptroller of the Currency and Office of Thrift Supervision, 2011, OCC and OTS Mortgage Metrics Report Fourth Quarter 2010, available at: http://www.occ.gov/news-issuances/news-releases/2011/nr-ia-2011-38.html
Office of the Special Inspector General for the Troubled Asset Relief Program (SIGTARP), 2011, Quarterly Report to Congress, April 28.
Posner, E.A. and L. Zingales, 2009, “Loan Modification Approach to the Housing Crisis,” American Law and Economics Review, Vol. 11(2), pp. 575–607.
Scarberry, M.S., 2010, “A Critique of Congressional Proposals to Permit Modification of Home Mortgages in Chapter 13 Bankruptcy,” Pepperdine Law Review, vol. 37, pp. 635.
Treasury, 2011, Making Home Affordable, Program Performance Report Through April 2011.
Tsounta, E., 2011, “U.S. Housing Market—Excessive Price Weakness?” in United States—Selected Issues Paper, Washington, DC: International Monetary Fund.
White, M.J., and N. Zhu, 2009, “Saving Your Home in Chapter 13 Bankruptcy,” Unpublished University of California Working Paper, March.
Prepared by John Kiff (MCM) and Evridiki Tsounta (WHD).
Before a modification becomes permanent, there is a typical “trial” period of three months which allows the loan servicer to test the borrower’s ability to make the modified loan payment before finalizing the modification.
Back-end DTI is calculated by dividing all debt-related payments (not just mortgage payments) by the homeowner’s gross income.
TARP investment authority expired on October 3, 2010; Treasury can only use the funds to administer existing housing programs (SIGTARP, 2011).
Front-end DTI is calculated by dividing all mortgage-related payments (including insurance and property taxes, but excluding mortgage insurance premia) by the homeowner’s gross income.
Most loans that are securitized in the United States are managed by third-party servicers as agents for the trusts that represent the interests of the MBS investors. For a comprehensive discussion of servicing economics see Box 3.7 in IMF (2011) and Levitin and Twomey (2011).
The calculations are based on the following observations: Corelogic (2011) reports that negative equity amounted to $750 billion at end-2010, of which $460 billion, is severely underwater, i.e., it would receive 10 cents on a dollar based on the HAMP-PRA’s servicer’s incentive scale. The remaining $290 billion negative equity would receive somewhat larger incentives per dollar, estimated at most at around $52 billion. In addition, for each foreclosure $3,000 would be provided as servicers’ and investors’ incentives (the latter amounts to around $1,000 based on actual data disbursed thus far to capture 50 percent of the difference between the mortgage servicing fees pre-and post-modification) bringing the aggregate fiscal cost for around 11 million principal writedowns to $130 billion. On average, each writedown would thus cost $12,000.
In order to reduce any remaining moral hazard risk, Posner and Zingales (2009) suggest including a variation of the H4H future home price appreciation clawback.
For example, the Mortgage Bankers Association has predicted that mortgage interest rates would jump by between 150–200 basis points and down payment requirements would increase to 20 percent or more if the exemption is removed (Kittle, 2007). In contrast, Dubitsky et al. (2009) and Levitin (2009a) find that the mortgage markets are virtually indifferent to cramdown risk, and Levitin and Goodman (2008) find that for high-risk borrowers, the exemption may be worth 12 to 16 basis points; the latter two analyses, however, have been vigorously criticized in Scarbery (2010).
To alleviate clogs in bankruptcy courts and minimize judge’s discretionary power, Levitin (2009b) and Blackrock (2009) suggest creating a special, streamlined and standardized mortgage bankruptcy Chapter.
For a more detailed discussion of the farm foreclosure crisis, please refer to Fitzpatrick and Thomson (2010).
A short sale is a home sale at a price insufficient to cover the outstanding mortgage, where the lender agrees to accept the receipts from the sale in exchange for releasing the lien. In the deed-in-lieu arrangement, the borrower transfers the title to the house to the lender, and the lender drops the claim against the borrower. In these cases, the houses are typically sold at a discount of around 13 percent.
In general, GSE loans are less likely than non-GSE loans to be underwater, and those that are underwater are more likely to be current and have mortgage insurance and/or second liens.
The GSE participation in writedowns would of course have a direct and immediate cost to the GSEs and ultimately a fiscal cost, given their status under conservatorship. In addition, there would be initial costs associated with operationalizing such writedowns.
