Recently, Federal Reserve Chairperson, Ben Bernanke, took a public position on the issue of foreclosures and loan modifications. A White Paper was sent to the House of Representatives’ Committee on Financial Services addressing the severity of the nation’s housing problem and offering possible solutions, with a stress on avoiding foreclosures.
The White Paper offers a thorough economic understanding of the housing problem with lengthy analysis and numerous statistics which you might expect from the economists at the Federal Reserve.
The first paragraph on housing conditions sets the tone of the discussion:
“House prices for the nation as a whole (figure 1) declined sharply from 2007 to 2009 and remain about 33 percent below their early 2006 peak, according to data from CoreLogic. For the United States as a whole, declines on this scale are unprecedented since the Great Depression. In the aggregate, more than $7 trillion in home equity (the difference between aggregate home values and mortgage debt owed by homeowners)—more than half of the aggregate home equity that existed in early 2006—has been lost. Further, the ratio of home equity to disposable personal income has declined to 55 percent (figure 2), far below levels seen since this data series began in 1950.”
The paper is directed towards helping homeowners stay in their house by finding alternative solutions. And if a homeowner cannot keep a home, then alternatives to foreclosure are considered.
The paper looks at specific situations of homeowners—those who may be able to refinance, though who can qualify for a loan modification, those who are temporarily unemployed, those who can avoid foreclosure by conducting a short sale or offering a deed-in-lieu, those who might like to stay in the home they have lost and rent it.
Renting out foreclosures is also a second major thread of the piece, a parallel issue to loan concerns. The paper’s position is that it would be better to rent out foreclosed homes. This would include renting by banks until they can sell them and also purchases of blocks of homes by big investors. The idea is that renting would stop the deterioration of the properties, take the houses off the market and reduce the continuing price plunge of foreclosed properties, and this would buoy up the home values of the entire neighborhood.
The Federal Reserve points out that many houses were sold to people who could not afford them, so the rental market should actually be bigger today, and should have been bigger in the past, if proper loan policies were followed.
There are good ideas in the white paper. Potential solutions are provided. The many paradoxes and contradictions in a problem are highlighted. And many discussions while not offering a solution seem to lead up to a solution, if one is bold enough.
Also, there are some weaknesses in the statement. The white paper does not see principal reduction in a loan modification as a solution. So it focuses only on other tactics. It shies away from a hard line against the banks—fines, Justice Department actions, putbacks from investors to banks etc.
Another fault lies in the discussion of the strict lending policies by banks without a means to alter their behavior. The paper points out that banks are using more stringent guidelines than are necessary—higher than the GSEs (Fannie Mae, Freddie Mac), and this is not obligatory, and this is hampering demand and sales, and lowering overall house prices. One obvious solution is to require banks to use GSE criteria if they want to use GSE money.
There is no significant section in the paper on promoting housing demand through tax incentives to buyers which would certainly be an important element of a housing solution.
The conversation about REO to renting seems to minimize the impact of low auction prices on community house values, though it is interesting and strives to be comprehensive.
Despite the weaknesses, overall, the white paper is a breath of fresh air. It breaks the stunning silence on the major issue dragging down the economy: Housing. It targets a main problem as loan modifications. It takes a broad view on the many complex issues. And it offers some thoughtful solutions.
And it certainly will set the stage for solutions: inferred by the discussion, selected by process of elimination or just simply new and surprising.
Below are excerpts on the white paper.
Basic points of the white paper:
1. Convert foreclosures to rentals
“Reducing some of the barriers to converting foreclosed properties to rental units will help redeploy the existing stock of houses in a more efficient way. Such conversions might also increase lenders’ eventual recoveries on foreclosed and surrendered properties.”
2. Increase housing demand and purchases
“Obstacles limiting access to mortgage credit even among creditworthy borrowers contribute to weakness in housing demand, and barriers to refinancing blunt the transmission of monetary policy to the household sector. Further attention to easing some of these obstacles could contribute to the gradual recovery in housing markets and thus help speed the overall economic recovery.”
“Finally, foreclosures inflict economic damage beyond the personal suffering and dislocation that accompany them. In particular, foreclosures can be a costly and inefficient way to resolve the inability of households to meet their mortgage payment obligations because they can result in ‘deadweight losses,’ or costs that do not benefit anyone, including the neglect and deterioration of properties that often sit vacant for months (or even years) and the associated negative effects on neighborhoods. These deadweight losses compound the losses that households and creditors already bear and can result in further downward pressure on house prices.”
3. Expand loan modifications
“Some of these foreclosures can be avoided if lenders pursue appropriate loan modifications aggressively and if servicers are provided greater incentives to pursue alternatives to foreclosure.”
4. Greater use of short sales and deed-in-lieu
“And in cases where modifications cannot create a credible and sustainable resolution to a delinquent mortgage, more-expedient exits from homeownership, such as deeds-in-lieu of foreclosure or short sales, can help reduce transaction costs and minimize negative effects on communities.”
5. Change Fannie Mae and Freddie Mac policies
“Intertwined in these issues is the unresolved role of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, in both the near term and long term. The GSEs hold or guarantee significant shares of delinquent mortgages and foreclosed properties. Because of their outsized market presence, the GSEs’ actions affect not only their own portfolios, but also the housing market overall. However, since September 2008, the GSEs have operated in conservatorship under the direction of the Federal Housing Finance Agency (FHFA), with specific mandates to minimize losses for taxpayers and to support a stable and liquid mortgage market.
In many of the policy areas discussed in this paper—such as loan modifications, mortgage refinancing, and the disposition of foreclosed properties—there is bound to be some tension between minimizing the GSEs’ near-term losses and risk exposure and taking actions that might promote a faster recovery in the housing market. Nonetheless, some actions that cause greater losses to be sustained by the GSEs in the near term might be in the interest of taxpayers to pursue if those actions result in a quicker and more vigorous economic recovery.”
Excerpts on specific topics
On loan policies of banks
“As a result of these developments, mortgage credit conditions have tightened dramatically from their pre-recession levels. Mortgage lending standards were lax, at best, in the years before the house price peak, and some tightening relative to pre-crisis practices was necessary and appropriate. Nonetheless, the extraordinarily tight standards that currently prevail reflect, in part, obstacles that limit or prevent lending to creditworthy borrowers. Tight standards can take many forms, including stricter underwriting, higher fees and interest rates, more-stringent documentation requirements, larger required down payments, stricter appraisal standards, and fewer available mortgage products.”
“Other data show, for instance, that less than half of lenders are currently offering mortgages to borrowers with a FICO score of 620 and a down payment of 10 percent (figure 5)—even though these loans are within the GSE purchase parameters. This hesitancy on the part of lenders is due in part to concerns about the high cost of servicing in the event of loan delinquency and fear that the GSEs could force the lender to repurchase the loan if the borrower defaults in the future.”
“Reduced mortgage lending is also notable among potential first-time homebuyers, who are typically an important source of incremental housing demand. These households often have relatively new credit profiles and lower-than-average credit scores, as they tend to be younger and have fewer economic resources to make a large down payment. Consumer credit record data show that the share of 29- to 34-year-olds getting a first-time mortgage was significantly lower in the past 2 years than it was 10 years earlier.”
“A government-facilitated REO-to-rental program could take many forms. The REO holder could rent the properties directly, sell the properties to a third-party investor who would rent the properties, or enter into a joint venture with such an investor. In making this decision, policymakers should consider what program design will provide for the best loss recoveries and the best outcomes for communities.”
“An REO-to-rental program that relies on sales to third-party investors will be more viable if this cost-pricing differential can be narrowed. REO holders will likely get better pricing on these sales if the program is designed to be attractive to a wide variety of investors. Selling to third-party investors via competitive auction processes may also improve the loss recoveries. Providing investors with debt financing will likely also affect the prices they offer on bulk pools of REO properties. As noted, such financing is largely unavailable now, thus limiting the number of potential investors. In the current tight mortgage lending environment, private lenders may not have the capacity to fund a large-scale rental program, and it may be appropriate for REO holders to fill the gap. However, whether such funding should be subsidized is an important question. Subsidized financing provided by the REO holder may increase the sales price of properties, but at the cost of reducing the REO holder’s future income stream. If so, the costs of such financing need to be accounted for in the rental program.”
“In addition, a program that minimizes the amount of time that a vacant property lingers in REO inventory before being rented would reduce disposition costs to the REO holder. These costs might be reduced by including properties that are already rented, such as properties rented under the provisions of the Protecting Tenants at Foreclosure Act. Another possibility is to auction to investors the rights to acquire, in a given neighborhood, a future stream of properties that meet certain standards instead of auctioning the rights to current REO holdings. A third possibility is to encourage deed-for-lease programs, which circumvent the REO process entirely by combining a deed-in-lieu of foreclosure—whereby the borrower returns the property to the lender—with a rent-back arrangement in which the borrower remains in the home and pays market rent to the lender.”
“In light of the current unusually difficult circumstances in many housing markets across the nation, the Federal Reserve is contemplating issuing guidance to banking organizations and examiners to clarify supervisory expectations regarding rental of residential REO properties by such organizations while such circumstances continue (and within relevant federal and statutory and regulatory limits). If finalized and adopted, such guidance would explain how rental of a residential REO property within applicable holding-period time limits could meet the supervisory expectation for ongoing good faith efforts to sell that property. Relatedly, if a successful model is developed for the GSEs to transition REO properties to the rental market, banks may wish to participate in such a program or adopt some of its features.”
Refinancing and HARP
“GSE fees known as loan-level pricing adjustments (LLPAs) are another possible reason for low rates of refinancing. Under normal circumstances, LLPAs are used to provide higher compensation to the GSEs for the risk that they undertake when new loans are extended to borrowers with high loan-to-value (LTV) ratios or low credit scores. In a HARP refinancing, however, the GSEs already carry the credit risk on the original mortgage, and refinancing to a lower rate could even lower the credit risk of some such loans; thus, it is difficult to justify imposing a higher LLPA when refinancing in this circumstance.”
“To reduce these and other obstacles to refinancing, the FHFA announced changes to HARP in October 2011.31 LLPAs for HARP loans were eliminated for borrowers shortening the term of their loans to 20 years or less and reduced for longer-term loans, certain representation and warranty requirements were waived, loans with LTVs greater than 125 percent were made eligible for the program, the appraisal process was largely automated, servicers were given greater flexibility to notify borrowers of their eligibility for refinancing through HARP, and private mortgage insurers agreed to facilitate the transfer of mortgage insurance. Some estimates suggest that another million or so homeowners could refinance their mortgages with these changes in effect.”
“An important group of borrowers who are not able to take advantage of the HARP program is homeowners with high LTVs but whose mortgages are not guaranteed by the GSEs. For the most part, these borrowers are not able to refinance through any public or private program. One possible policy option might be to expand HARP—or introduce a new program—to allow the GSEs to refinance non-GSE, non-FHA loans that would be otherwise HARP eligible. Unlike HARP refinances, however, these refinances would introduce new credit risk to the GSEs because the GSEs do not currently guarantee the loans, even if the loans were offered only to borrowers who are current on their payments and would meet underwriting standards (for example, debt-to-income ratio and credit score), if not for their high loan-to-value ratios. Perhaps 1 million to 2-1/2 million borrowers meet the standards to refinance through HARP except for the fact that their mortgages are not GSE-guaranteed.”
“The structure of the HARP program highlights the tension between minimizing the GSEs’ exposure to potential losses and stabilizing the housing market. Although the GSEs would take on added credit risk from expanding HARP to non-GSE loans, the broader benefits from an expanded program might offset some of these costs. In particular, some homeowners who are unable to refinance because of negative equity, slightly blemished credit, or tighter underwriting standards could reduce their monthly payments significantly, potentially reducing pressures on the housing market.”
Loan modifications and HAMP
“About 880,000 permanent modifications have been made through the voluntary Home Affordable Modification Program (HAMP), which is part of the Making Home Affordable (MHA) program. HAMP pays incentives to lenders, servicers, and borrowers to facilitate modifications. Among its key program terms, HAMP reduces monthly payments for qualifying borrowers to 31 percent of income. For borrowers who have received HAMP modifications, the help is often substantial. For example, the median monthly payment after a permanent HAMP modification is about $831, compared with about $1,423 before the modification. Millions of additional mortgages have been modified by lenders, guarantors, and the FHA.”
“On the other hand, the 31 percent payment-to-income target has also precluded the participation of borrowers who might benefit from a modification even though their first-lien payment is already less than 31 percent of income. One potential method of expanding the reach of HAMP that may be worth exploring would involve allowing payments to be reduced below 31 percent of income in certain cases.”
“Instead of a longer-term modification, a payment deferral may be more helpful to temporarily unemployed borrowers whose income, it is hoped, will rise in the near future. MHA has introduced an unemployment forbearance program under which servicers grant 12 months’ forbearance. Resources from the Hardest Hit Fund, which was created by the Department of the Treasury (Treasury) under the Troubled Asset Relief Program, have been used to provide assistance to unemployed homeowners through a variety of programs run by state housing finance agencies.”
About principal reduction
“An alternative to large-scale principal reduction for addressing the barriers that negative equity poses for mortgage refinancing and home sales could involve aggressively facilitating refinancing for underwater borrowers who are current on their loans, expanding loan modifications for borrowers who are struggling with their payments, and providing a streamlined exit from homeownership for borrowers who want to sell their homes, such as an expanded deed-in-lieu-of-foreclosure program (described later). This approach focuses on reducing payments rather than reducing principal per se, and could be more effective at keeping committed borrowers in their homes if affordability is the prime consideration driving default.”
About short sales and deed-in lieu
“Despite the potential for loan modifications and targeted forbearance programs to prevent unnecessary foreclosures, many borrowers will not be able to keep their homes. In these cases, the most efficient solution may be to find an alternative to foreclosure such as a short sale or a deed-in-lieu-of-foreclosure (DIL). In a short sale, the home is sold to a third-party buyer offering less than the amount owed by the homeowner. In a DIL, there is no sale, but the property is transferred directly to the lender or guarantor, rather than going through the formal foreclosure process. Both options are within the bounds of mortgage contracts and avoid some of the economic damage potentially caused by the foreclosure process. Short sales can be attractive because the property is transferred to a (presumably sustainable) new owner, keeping the property out of REO and reducing potential negative effects on communities from vacant properties. DILs can also be helpful because they can sometimes be easier to execute than a short sale and because they can fit into an REO-to-rental program to prevent a discounted sale that would otherwise occur. Both options may be particularly attractive to borrowers if lenders partially or fully waive borrower liability for deficiency balances. The MHA’s Home Affordable Foreclosure Alternatives program provides incentive payments to facilitate both short sales and DILs.”
About mortgage servicers
“Also, the fee structure of the servicing industry helped create perverse incentives for servicers to, for example, reduce the costs associated with working out repayments and moving quickly to foreclosure, even when a loan modification might have been in the best interest of the homeowner and investor.”
From the conclusion
“The challenges faced by the U.S. housing market today reflect, in part, major changes taking place in housing finance; a persistent excess supply of homes on the market; and losses arising from an often costly and inefficient foreclosure process (and from problems in the current servicing model more generally). The significant tightening in household access to mortgage credit likely reflects not only a correction of the unsound underwriting practices that emerged over the past decade, but also a more substantial shift in lenders’ and the GSEs’ willingness to bear risk. Indeed, if the currently prevailing standards had been in place during the past few decades, a larger portion of the nation’s housing stock probably would have been designed and built for rental, rather than owner occupancy. Thus, the challenge for policymakers is to find ways to help reconcile the existing size and mix of the housing stock and the current environment for housing finance. Fundamentally, such measures involve adapting the existing housing stock to the prevailing tight mortgage lending conditions—for example, devising policies that could help facilitate the conversion of foreclosed properties to rental properties—or supporting a housing finance regime that is less restrictive than today’s, while steering clear of the lax standards that emerged during the last decade. Absent any policies to help bridge this gap, the adjustment process will take longer and incur more deadweight losses, pushing house prices lower and thereby prolonging the downward pressure on the wealth of current homeowners and the resultant drag on the economy at large.
In addition, reducing the deadweight losses from foreclosures, which compound the losses that households and creditors already bear and result in further downward pressure on house prices, would provide further support to the housing market as well as provide assistance to struggling homeowners. Policymakers might consider minimizing unnecessary foreclosures through the use of a broad menu of types of loan modifications, thereby allowing a better tailoring of modifications to the needs of individual borrowers; and servicers should have appropriate incentives to pursue alternatives to foreclosure. Policymakers also may want to consider supporting policies that facilitate deeds-in-lieu of foreclosure or short sales in order to reduce the costs associated with foreclosures and minimize the negative effects on communities. Restoring the health of the housing market is a necessary part of a broader strategy for economic recovery. As this paper suggests, however, there is unfortunately no single solution for the problems the housing market faces. Instead, progress will come only through persistent and careful efforts to address a range of difficult and interdependent issues.”
Here is the link to the Federal Reserve site to obtain the entire white paper:
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