Loan Modifications a Failure

Megan McCardle at The Atlantic has a point in assessing the success of the Making Home Affordable Loan Modification Program. The program, she notes, was designed for people who were facing payment shock when their adjustable loans reset. However, with interest rates being so low, most adjustable rates adjusted downward. To illustrate: a $300,000, 30-year loan that had a five-year, interest-only period at 5.75% would have a current payment of $1,437 a month. After the five-year period ends, the unpaid loan balance ($300,000) is reset such that it can be paid off over the remaining 25 years. Most adjustable mortgages were tied to the 1 yr. Treasury rate, which today is about 0.37%, and carried margins of 2.25%. That means that, if reset today, the new interest rate (adjustable annually) would be 2.625%. This would create a payment on the balance of $1,365 a month, a savings of $72. So this isn't really the problem.

Megan writes that the two main problems are 1) negative equity and 2) unemployment. People who are unemployed and upside-down on their mortgages are not likely to be able to continue making the payments. No modification to reduce the payments would help them since they have no incomes, and have likely exhausted all their liquid assets to help them stay afloat just to survive. By that time they've also maxxed out their credit cards, so no one's going to give them a loan when they're so deeply in debt and have no jobs or woefully inadequate incomes.

Her solution is simply to figure out a way to create a streamlined process by which distressed homeowners can sell their homes in a "short sale."

Now, I've been a mortgage professional since 1985. I got my start in underwriting (i.e., decisioning) loans, and now work in sales for one of the largest mortgage lenders in the country. Reading her article, I admired her take on the Home Affordable Modification Program, and how it's essentially been a bust for most homeowners, simply prolonging the inevitable.

I don't, however, see the government streamlining the process of arranging a short sale as a workable solution. There are just too many moving parts to today's mortgage market: 1) the homeowner/borrower, for whom the current modification legislation was written; 2) the lender, who gets to avoid reporting a non-performing asset and damaging shareholder value; 3) the investor(s), who would like to maintain some amount of income stream from the asset they purchased rather than write down the lion's share of their portfolio; and 4) the taxpayers, whose taxes will for years be used by the government to pay for interest on all the borrowing the government has to do to keep all these balls in the air. It is an attractive idea to simply cut bait and start over. To get homeowners to admit en masse that they messed up and borrowed more than they could afford and that their best solution is to sell short and move on is a long shot. Schools have been selected, commutes shortened/made more manageable, community involvement begun. To get lenders to write off huge amounts of debt would be anathema to their balance sheets and global investor confidence in the financial sector at a crucial time, so that's a long shot too. To get investors to write off their investments would have far-reaching problems for the federal government, since the government now owns the two largest mortgage investors in the country (Fannie and Freddie).

But if it had to be done, what could be streamlined in the process of a short sale that would create the least amount of pain? Well, the most obvious one is the investor since their buying mortgage-backed securities was not a guarantee of their success as an investment. Then, again, you still have the problem that hurts the government, but that's the most resilient of all of these actors.

Perhaps the solution goes like this:

Any homeowner who agrees to a streamlined short sale is guaranteed to walk away from the sale with no tax liability for the debt forgiveness. This is usually the big shock after the short sale is consummated. However, once free of the house they could not afford, they would have to put down at least 20% on their next purchase and would be subject to tighter restrictions on their affordability/other liabilities.

Any lender that was forced into a short sale would be allowed to retain 75% of the new mortgages. Because most likely the new loan would be one they could sell to Fannie or Freddie, the gain they would realize on that sale would help offset the losses they'd incurred in the short sale.

Investors who sustained a loss on the short sale and elected to purchase the mortgage for the new buyer could do so at a reduced cost. Typically, the investor would buy the loan at par plus 0.5%, but buying a short sale mortgage could be at par plus 0.25%, also helping to offset their losses. This would affect the lender's ability to recoup their losses more quickly, but that would be the trade-off to keep the money flowing.

Not a perfect solution, of course, but one that could take the pressure off a modification program that doesn't serve the needs of any party involved.