loan modification analysis has a lot of moving parts

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"U.S. Government Foreclosure Mitigation Policies: Too Little, Too Late? (Part 2) Jump to Comments

By John Kiff

In the first post in this series, I gave a very broad brush overview of the three government foreclosure mitigation programs that have been introduced since 2007. In this post, I’m going to dive a bit deeper into the details of the Home Affordable Modification Program (HMP), the more recent of the government’s two active foreclosure mitigation plans. I’ll get into the Hope for Homeowners (H4H) program in the next post.

The point of both programs is to get the borrower’s payment-to-income (PTI) ratio down to 31 percent. The PTI is calculated by dividing all mortgage-related payments (including insurance and property taxes, but excluding mortgage insurance premia) by the homeowner’s gross income. HMP does it by offering to subsidize the cost to the lenders of temporarily reducing monthly payments to the 31 percent PTI ratio.

HMP gives lenders a subsidy of up to one-half the difference between the monthly payments at the 31 percent PTI ratio, and what the payment would have been at a 38 percent ratio, for up to five years. In addition, they get $1,500 for every current loan modified to encourage the offering of early intervention (rather than waiting until the borrower is seriously delinquent). Studies have shown that early intervention results in lower redefault rates (see “loan modifications and redefault risk”).

Servicers also get $1,000 for each modification, plus another $500 if the borrower was still current and $1,000 each year (for up to three years) that the borrower stays current (“pay for success”). One of the reasons cited for the H4H’s poor results has been that servicers are unincentivized and under resourced.

HMP also subsidizes lender costs of extinguishing junior liens (up to 12 percent of the unpaid balance), or subsidize junior lien holder costs of temporarily reducing interest rates to as low as one percent. Junior lien servicers who opt to reduce the interest rate will receive $500 upfront and $250 per year for up to five years. For more information see the April 28 update.

In order to make this all more concrete, I’m going to run some numbers on a hypothetical seriously delinquent $200,000 10 percent 30-year mortgage on a property that was worth $250,000 at origination (an 80 percent LTV). The monthly payment is $2,380, including $625 of insurance and property taxes. The borrower’s gross annual income is assumed to be $57,120, to imply a current PTI of 50 percent.

In order to get the PTI down to 31 percent the interest rate must be reduced from 10 to 3.125 percent (see table). Lender subsidies will amount to $326 every month that the modified loan stays current (half the difference between payments at the 38 and 31 percent DTI levels) for up to five years. Since the rate is below the current Freddie Mac Weekly Primary Mortgage Market Survey (PMMS) rate, after five years, the rate increases by one percent every year until it reaches the PMMS rate. I assume that the PMMS Rate is five percent.

The result of all of this, in net present value (NPV) terms using a 7.50 percent discount rate, is an effective write down from $200,000 to $122,530 plus $8,143 if the modified loan stays current for five years. However, before racing ahead into this modification, the servicer will compare this potential $130,673 NPV to the liquidation value in foreclosure.

The table below estimates these liquidation values in three home price depreciation (HPD) scenarios. For example, at zero, the lender will net about $148,750, making foreclosure a better alternative to an HMP modification. At 25 percent the net is $106,563, making it a close call between modification and foreclosure. At 50 percent HPD the $64,375 recovery value makes modification a possibly better choice.

The table below shows the outcomes for the HMP modifications under the three HPD scenarios, compared to the outcomes if the servicer just rides out the loans (“status quo”). The dollar numbers are the NPVs, and the assumed probabilities are in the parentheses (more about those later). It suggests that HMP modifications aren’t likely work out so well in the zero and 25 percent HPD scenarios for this particular example, because their expected NPVs are less than those in the status quo scenarios (see below for more detail). However, in the deep depreciation scenario (HPD = 50 percent), the HMP modifications have a have higher expected NPVs.

In general, the ultimate success of the HMD modifications will depend on whether the modified loan stays current (“cures”) or redefaults. The decision as to whether to modify will also depend on the likelihood of the unmodified loan becoming or staying current. The Treasury is making available to servicers an NPV calculator which embeds their suggested assumptions for the two key default probabilities, and large servicers (with books exceeding $40 billion) “may” use their own. I’m not a servicer, so for now, all I have to go on are the HMP NPV guidelines which remain vague on many key details and parameters.

In the above table I assume that the default probability on the unmodified seriously delinquent loan is 85 percent and 30 percent if it is modified. The expected NPV on the modified loan is $147,493 or less (depending on the amount of post-modification HPD), and $164,090 on the unmodified loan. In all but the 50 percent HPD scenario, for this specific example, it looks like it would be better not to modify.

Of course, as we discussed in the last post, default rates on modified loans are likely to vary according to the type of modification and the degree to which the loan balance exceeds the value of the underlying property (“negative equity”). Hence, a more sophisticated analysis would vary the probabilities according to the negative equity, which might even swing the evaluation towards the status quo in the 50 percent HPD scenario.

However, we’re not quite done yet! The hypothetical loan we just worked over was seriously delinquent. What about current borrowers? Recall that HMP is going to pay lenders $1,000 and servicers $500 for every current loan that they modify under HMP. However, although proactive modifications can be a good thing, they can backfire if borrowers who would have otherwise stayed current come forward for modifications. HMP controls this “moral hazard” risk by requiring that the borrower give proof of a significant change in income or expenses, to the point that the current mortgage payment is no longer affordable. However, keep in mind that, despite all the nasty headlines, there are still lots of nonprime loans that are not delinquent, so this risk could be significant.

Anyways, one of the key take aways from this post should be that loan modification analysis has a lot of moving parts, many of which I’m leaving out of this example (e.g., delinquency and prepayment timing, the evaluation horizon, and discount rate). Also, there are numerous other combinations and permutations of DTIs, LTVs and HPDs. In the next post in this series, I’ll go through a similar analysis of the H4H program, and show how it fits with the HMP under different DTI/LTV/HPD scenarios.

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* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management."