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Special Report
Using Shared-Equity Agreements to
Reduce Foreclosures: Policy and Analysis
Robert Manning, PhD
Research Professor and Director of
Center for Consumer Financial Services
E. Philip Saunders College of Business
Rochester Institute of Technology
Filene Research Institute
Deeply embedded in the credit union tradition is an ongoing search for better ways to
understand and serve credit union members. Open inquiry, the free flow of ideas, and
debate are essential parts of the true democratic process.
The Filene Research Institute is a 501(c)(3) not-for-profit research organization dedicated
to scientific and thoughtful analysis about issues affecting the future of consumer finance.
Through independent research and innovation programs the Institute examines issues
vital to the future of credit unions.
Ideas grow through thoughtful and scientific analysis of top-priority consumer, public
policy, and credit union competitive issues. Researchers are given considerable latitude
in their exploration and studies of these high-priority issues.
The Institute is governed by an Administrative Board made up of the credit
union industry’s top leaders. Research topics and priorities are set by the Research Council, a select group of credit union CEOs, and the Filene Research Fellows,
a blue ribbon panel of academic experts. Innovation programs are developed
in part by Filene i3, an assembly of credit union executives screened for
entrepreneurial competencies.
Progress is the constant
replacing of the best there
is with something still better!
— Edward A. Filene
The name of the Institute honors Edward A. Filene, the “father of the United States
credit union movement.” Filene was an innovative leader who relied on insightful
research and analysis when encouraging credit union development.
Since its founding in 1989, the Institute has worked with over 100 academic institutions
and published hundreds of research studies. The entire research library is available online
at www.filene.org.
About the Author
Robert D. Manning, PhD
Robert D. Manning is research professor and director of the Center for Consumer Financial
Services and past Caroline Werner Gannett Chair of the Humanities, Rochester Institute of
Technology. Author of the widely acclaimed Credit Card Nation: America’s Dangerous
Addiction to Credit (2000), which received the 2001 Robert Ezra Park Award for Outstanding
Contribution to Sociological Practice, Dr. Manning is a specialist in the deregulation of
retail banking, consumer finance, comparative economic development, immigration,
and globalization.
A frequently invited expert before U.S. Congressional Committees, Dr. Manning’s research has
influenced public policy debate on the statutory regulation of retail banking and consumer
debt in the United States and other countries. In January of 2008, Dr. Manning testified at the
Senate Banking Committee’s hearing on “Examining the Billing, Marketing, and Disclosure
Practices of the Credit Card Industry, and Their Impact on Consumers.” He has also served as an
expert witness in numerous lawsuits against the credit card industry. A documentary based on
his research, In Debt We Trust: America Before the Bubble Bursts at www.indebtwetrust.com,
was released in March 2007. Dr. Manning’s popular Web site includes research, public policy
analyses, and educational programs at www.creditcardnation.com. Dr. Manning is also a member
of the Filene Fellows Program.
About the Contributor
George A. Hofheimer
George A. Hofheimer is the chief research officer for the Filene Research Institute, where he
oversees a large pipeline of economic, behavioral, and policy research related to the consumer
finance industry. He is the current vice chairman of the board of directors at the Williamson
Street Grocery Cooperative, a $17 million natural foods store. He earned a BBA and an MBA
from the University of Wisconsin–Madison.
Executive Summary
This report supplements a January 2009 study entitled Keeping People in Their Homes:
Policy Recommendations for the Foreclosure Crisis in Michigan, where we examined the
causes and impacts of the foreclosure problem in Michigan. The original study
proposed 10 recommendations to mitigate the number of home foreclosures. At the
request of the Michigan Credit Union Foundation, this report expands upon one of
the proposals, which we termed shared-equity loan modifications. Shared-equity loan
modifications reduce the principal balance of a mortgage with the promise of sharing
home equity appreciation that may materialize in the future between the lender and
the borrower. The goal, as in most loss mitigation programs, is to avoid foreclosure
by making a mortgage more affordable for the borrower. A potential added benefit
of this approach is that the underlying value of the real estate assets secured by the
mortgage is written down to the actual current market value.
In support of this proposal, we examine and evaluate current developments in the
mortgage market, including:
•
Recent foreclosure trends: They are increasing nationwide, with the most
serious foreclosure problems concentrated in a handful of states,
including Michigan.
•
Recent mortgage quality trends: Delinquencies are increasing for all types
of mortgages, including prime and subprime. Additionally, the number of
mortgages that are “under water” is expected to reach 14.6 million by the
end of 2009, with Michigan having the second highest rate of under water
mortgages.
•
Efficacy of mortgage loan modification programs: Data indicate that
modifications have been met with little success, and, in many cases, loan
modifications do not lead to lower payments for consumers. Redefault
rates are nearly 50% for some mortgages.
•
Recent policy prescriptions: President Obama’s Homeowner
Affordability and Stability Plan (HAS) will help make monthly mortgage
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payments more affordable for up to four million consumers but does
little for consumers who are currently under water.
The shared-equity loan modification proposal aims to address the needs of under
water consumers by creating a market incentive that shares the risk and financial gain
between the mortgage holder and the consumer arising from a rapidly established
and stabilized housing price floor. In an illustrative example, a consumer who
purchased a house for $150,000 but now finds the value of her house at only
$120,000 would engage in a shared-equity loan modification with the lender by
refinancing the home with a first mortgage of $120,000 and a second
mortgage/forbearance of $6,000 (20% of debt concession) that is due in 10 years.
The remaining concession of $24,000 would be negotiated as a shared-equity loan
modification with terms that would be contingent on the length of time of
homeownership after the principal reduction.
While there are no explicit legislative or regulatory reasons this recommendation
would not work, the implementation problem occurs primarily with lenders and
servicers. Lenders and servicers are faced with what is termed a collective action
problem, because “no single servicer or group of servicers…has any economic
incentive to organize a pause in foreclosures or an organized deleveraging program
to benefit the group” (White, 2009). One way to surmount this roadblock is to pilot
the proposal with a handful of lenders and servicers and then demonstrate its utility
for a larger, standardized program. Credit unions, as nonprofit financial cooperatives,
may make an ideal choice for this initial pilot group.
We suspect once a comprehensive pilot program is implemented, lenders and
consumers will view shared-equity loan modifications as a favorable solution to the
current housing market situation. This solution will likely prove more favorable than
foreclosure, existing loan modification programs and the controversial “cramdown”
legislation being considered in the U.S. Congress1 for consumers in Michigan and
across the United States.
1
H.R. 1106, “Helping Families Save Their Home” Act of 2009.
-2-
Introduction
In late 2008, the Michigan Credit Union Foundation requested a research report
addressing the impact of the current mortgage foreclosure crisis in Michigan. Our
research concluded that the meteoric rise of residential mortgage foreclosures was
the culmination of a series of unprecedented economic events that created an
unsustainable period of economic expansion. While various state, federal, and
private-sector initiatives were instituted to mitigate the foreclosure problem in 2007
and 2008, a great majority of these programs failed to effectively address the
foreclosure problem on a long-term, sustainable basis. In our analysis, we classified
and segmented the Michigan mortgage market by portfolio loans and pooled loans2
in order to develop the most appropriate and effective policy response.
Figure 1: Estimated First Mortgages in Michigan, June 2008
Commercial bank/thrift
Credit unions
Out-of-state banks
Total portfolio loans
Estimated pooled loans
Total residential loans
% of total
14.0%
4.8%
10.0%
28.8%
71.2%
100.0%
Amount (thousands)
$27,869,681
$9,525,002
$19,882,008
$57,276,691
$141,543,389
$198,820,080
Total number of
loans
232,247
79,375
165,683
477,306
1,179,528
1,656,834
We presented 10 key recommendations for reducing the number of foreclosures in
Michigan and across the U.S. Of these proposals, one is especially promising for
addressing the changing nature of the U.S. and Michigan home mortgage markets.
Shared-equity loan modification programs reduce the principal balance of a mortgage
with the promise of sharing home equity appreciation that may accrue in the future
between the lender and the borrower. The goal, as in most loss mitigation programs,
is to avoid foreclosure in the short-term by making a mortgage more affordable for
the borrower. A potential added benefit of this approach is that the underlying value
of the real estate assets secured by the mortgage are written down to the actual
current market value.
Portfolio loans are held by the financial institution on its balance sheet. Pooled loans are sold by a
financial institution to a commercial or government-sponsored entity for servicing and/or ownership.
2
-3-
To support this unique policy proposal, we supplement our original findings with a
thorough examination of:
•
Recent foreclosure trends.
•
Recent mortgage quality trends.
•
Efficacy of mortgage loan modification programs.
•
Recent policy prescriptions.
•
Proposal for shared-equity loan modification programs.
Recent Foreclosure Trends
The release of RealtyTrac’s U.S. Foreclosure Market Report for the first quarter of
2009, shows that foreclosure filings default notices, auction sale notices, and bank
repossessions reported a 9% increase from the previous quarter and an increase of
nearly 24% from the first quarter of 2008. The first quarter 2009 totals were the
highest monthly and quarterly totals since RealtyTrac began issuing its report in
January 2005. California, Florida, Arizona, Nevada, and Illinois accounted for nearly
60% of the nation’s foreclosure activity in the first quarter. Other states with
foreclosure rates ranking among the top 10 in the first quarter were Michigan,
Georgia, Idaho, Utah, and Oregon. In short, foreclosures continue to be a major
drag on the housing market and the larger economy as they account for a
disproportionate share of current home sales.
Figure 2: U.S. Foreclosure Market Data by State Q1 2009: Properties with Foreclosure Filings
Location
United
States
Michigan
(sixth)
Total
One
foreclosure
for every
housing
unit (rate)
% Change
from Q4
2008
% Change
from Q1
2008
190,543
803,489
159
9.16
23.63
10,530
33,184
136
-1.98
12.32
Number
of
Lis
defaults pendens
Notice
of
trustee
sale
Notice of
foreclosure
sale
Real
estate
owned
156,933
225,752
80,409
0
791
149,852
0
21,863
Source: RealtyTrac
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Recent Mortgage Quality Trends: Delinquencies
Mortgage delinquency rates are a strong predictor of future foreclosure rates.
Therefore, we provide a brief analysis of the most up-to-date data available for the
mortgage market. A recent report by the Office of the Comptroller of the Currency
(OCC) and the Office of Thrift
Almost 1 in 10 home mortgages is either delinquent or in foreclosure, and
analysts estimate that at as many as 6 million families could lose their
homes over the next 3 years in the absence of government action.
Supervision (OTS) highlights the
continuing deterioration of the
outstanding $11 trillion mortgage market, the following statistics include nearly twothirds of all U.S. residential mortgages. Overall, total current and performing loans at
banks declined sharply from 93.33% in the first quarter to 89.95% in the fourth
quarter of 2008. This includes 7.6% of mortgages that were “seriously delinquent,”
which is defined as at least 60 days late on mortgage payments.
Figure 3: Total Mortgage Portfolio Performance
Percent of all mortgage loans in the portfolio
First quarter
Second quarter Third quarter Fourth quarter
Current and performing
93.33%
92.61%
91.48%
89.95%
30-59 days delinquent
2.59%
2.85%
3.20%
3.44%
60-89 days delinquent*
0.97%
1.06%
1.29%
1.56%
90 or more days delinquent*
1.34%
1.37%
1.70%
2.45%
Bankruptcy 30 or more days delinquent*
0.35%
0.51%
0.56%
0.60%
Subtotal for seriously delinquent
2.66%
2.94%
3.54%
4.60%
Foreclosures in process
1.41%
1.59%
1.78%
2.00%
Number of mortgage loans in the portfolio
Current and performing
32,303,802
32,182,548
31,689,516
21,210,743
30-59 days delinquent
896,636
990,347
1,108,701
1,194,136
60-89 days delinquent*
335,517
368,527
446,339
540,263
90 or more days delinquent*
463,369
477,256
588,399
850,343
Bankruptcy 30 or more days delinquent*
122,053
176,849
192,929
207,077
Subtotal for seriously delinquent
920,939
1,022,632
1,227,667
1,597,683
Foreclosures in process
789,317
553,480
614,881
694,056
* Indicates seriously delinquent.
Source: OCC and OTS Mortgage Metrics Report – Disclosure of National Bank and Federal Thrift
Mortgage Loan Data. Fourth Quarter 2008, April 2009
-5-
A similar analysis of the U.S. credit union system illustrates a weakening of the
residential mortgage portfolio, but not to the same extent or severity as in the
commercial banking industry. Credit unions have been much less likely to underwrite
and retain the most risky first mortgages with low down payments, large resetting
payments and negative amortization features. However, as shown below, many credit
unions are experiencing substantial losses on home equity lines of credit (HELOCs)
and other second mortgage loans as property values have fallen and foreclosures and
bankruptcies have skyrocketed.
Figure 4: Credit Union Mortgages that are 60+ Days Delinquent: Percent of Total Outstanding
First Mortgage
HELOC & 2nd Mortgages
1.40
1.20
Percent
1.00
0.80
0.60
0.40
0.20
0.00
Dec-07
Mar-08
Jun-08
Source: Credit Union National Association.
-6-
Sep-08
Dec-08
Figure 5: Credit Union Mortgage $ Net Chargeoffs: Percent of Average Outstanding
First Mortgage
HELOC & 2nd Mortgages
0.9
0.8
0.7
Percent
0.6
0.5
0.4
0.3
0.2
0.1
0
Dec-07
Mar-08
Jun-08
Sep-08
Dec-08
Source: Credit Union National Association.
Figure 6: Distribution of Credit Unions and Number of Loan Modifications Currently Active
1st Mortgages
# of Credit Unions
200
180
Other Real Estate Loans
160
140
120
100
80
60
40
20
0
1
2
3
4
5
6
7
8
# of Loan Modifications Active
Source: Callahan and Associates.
-7-
9
10
>10
The performance of residential mortgage loans during this period of extraordinary
decline in the housing market and rapid deterioration of the U.S. macroeconomic
environment is directly influenced by the ability of households to obtain temporary
and long-term relief from their original lenders and current mortgage holders. It is
“A much larger foreclosure mitigation plan that includes mortgage write-downs
is necessary to significantly slow the foreclosure wave” (Zandi 2008).
important to note
that so-called
pooled loans (representing almost 70% of Michigan mortgages), which are not
directly owned by financial institutions, play an important role in whether delinquent
homeowners can obtain favorable modifications of their loans and avoid foreclosure.
These loans have been securitized by large wholesale institutions such as Freddie
Mac and Fannie Mae and resold to a host of private investors around the world. The
credit quality of these loans is on par with the bank and thrift industries, according to
recent analysis by the Mortgage Bankers Association of America. With almost $1
trillion in resetting mortgages (ARMS, interest only, option only) maturing over the
next three years, the mortgage market faces continued distress that will be
exacerbated by rising unemployment across the country. Analysts at Goldman Sachs
estimate future write-downs on the $1.3 trillion of total Alt-A mortgage debt
including both pooled and portfolio loans at $600 billion—almost as much as
expected in subprime losses. Together with option ARMs, many of which are
essentially the same as Alt-A, potential mortgage losses on these disproportionately
“jumbo loans” (over $729,000) could reach $1 trillion in the coming years as the
prices continue to fall the sharpest among more expensive homes3 (Economist, 2009)
Negative Equity
Between 2007 and 2008, the National Realtors Association reports that the median
sale price of existing homes dropped dramatically (15.5%), from $219,000 to
$198,100, and even more sharply over the last six months to $164,400 at the end of
February. Home prices are projected to drop on average another 10%, which will
increase the number of homeowners who will be under water on their mortgages to
about 14.6 million by fall 2009 (Zandi 2008, 2009; Zandi, Jaffee, and Melser 2008).
3
See Appendix 3 for a breakdown of Michigan vs. U.S. share of this subprime mortgage market.
-8-
In comparison, about 2.5 million homeowners had negative equity in their homes in
2006, jumping to 9 million in early 2008 (Armour 2008; Zandi et al. 2008). Further
analysis indicates that Michigan ranks second, only behind Nevada, with nearly one
out of two homes with negative equity or near negative equity as shown in Figure 7.
Figure 7: Percent of Homes at Negative Equity or Near Negative Equity Share
70.0%
60.0%
Near Negative Equity Share
Negative Equity Share
Nearly 50% of Michigan
mortgages are in or will soon be
in negative equity positions.
50.0%
Percent
40.0%
30.0%
20.0%
Wisconsin
Tennessee
Nebraska
Arkansas
Kansas
Texas
Iowa
Virginia
New Hampshire
Colorado
Georgia
Ohio
California
Florida
Arizona
Michigan
0.0%
Nevada
10.0%
Note: Near negative equity is 95% -100% loan to value mortgages.
Source: Author’s calculations and First American CoreLogic, 2009
Efficacy of Mortgage Loan Modification Programs
As stated in our previous report, the major policy interventions of 2007 and 2008
that were designed to reduce the number of foreclosures were largely unsuccessful
because they offered little, if any, long-term payment relief to homeowners. The
most recent snapshot of the performance of residential mortgages that were
modified in 2008 presents a comprehensive picture of mortgage servicing activities
of the industry’s largest mortgage servicers, representing nearly 66% of all mortgages
outstanding in the United States. Overall, the worst performing loans were in the
least creditworthy underwriting categories. As expected, the proportion of subprime
mortgages that were classified as seriously delinquent (60 or more days late) were the
highest—jumping from 10.75% in the first quarter to 16.70% at the end of the
fourth quarter of 2008. The proportion of Alt-A loans that were seriously delinquent
nearly doubled in this period—from 5.18% to 9.10%. Most disturbing, however, is
the even greater increase in prime loans that were seriously delinquent—jumping
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from 1.11% at the end of the first quarter to 2.40% at the end of the fourth quarter
of 2008.
Figure 8: Percent of Seriously Delinquent Loans
Percent of all mortgage loans in each category
First quarter
Second quarter
Third quarter
Prime
1.11%
1.30%
1.67%
Alt-A
5.18%
5.80%
7.05%
Subprime
10.75%
11.60%
13.52%
Other
2.88%
3.10%
3.57%
Overall
2.66%
2.94%
3.54%
Number of loans in the portfolio
Prime
251,091
301,069
384,781
Alt-A
185,050
208,770
252,319
Subprime
334,251
359,314
414,498
Other
150,547
153,479
176,069
Overall
920,939
1,022,632
1,227,667
Source: OCC and OTS, 2009.
Fourth quarter
2.40%
9.10%
16.40%
4.42%
4.60%
553,736
325,462
498,154
220,331
1,597,683
Figure 9 presents the distribution of the 423,152 residential mortgages that were
modified in 2008 by the size of the monthly payment adjustment. Approximately
one-quarter remained unchanged (26.6%), while one-eighth (12.5%) were reduced by
a maximum of 10%, and almost one-third (29.3%) were reduced by more than 10%.
Significantly, nearly one-third (31.6%) of these modified loans resulted in higher
monthly payments.
Figure 9: Changes in Monthly Payments for Loan Modifications
Percent of all
Number of modifications in each
modifications
category
Decreased by more than 10%
29.31%
124,008
Decreased by 10% or less
12.54%
53,083
Unchanged
26.58%
112,476
Increased
31.57%
133,585
Total
100%
423,152
Source: OCC and OTS Mortgage Metrics Report – Disclosure of National Bank and Federal Thrift
Mortgage Loan Data. Fourth Quarter 2008, April 2009.
Not surprisingly, over one-half of these modified mortgages that did not offer lower
monthly payments were seriously delinquent only nine months after the loan
modification. Significantly, monthly loan payments that did not change featured the
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worst performance: 41.9% were seriously delinquent only three months later and
increased nine months later to 53.5%. In contrast, those mortgages with the largest
payment reduction performed the best (13.8% to 26.2%) followed by those with
modest payment reductions (18.5% to 38.6%). Mortgage payments that increased
after modification deteriorated rapidly—from 29.2% seriously delinquent after three
months to 49.1% after nine months. The very strong statistical association between
reduced monthly payment modifications and high payment performance is presented
in the Figure 10. Nine months after the early 2008 mortgage modification, over onehalf (51.5%) of homeowners whose monthly payments either rose or remained
unchanged were seriously delinquent compared to about one-quarter (26.2%) whose
payments were reduced the most (over 10%), followed by those with modest
payment reductions (less than 10%) at 38.6%.
Figure 10: Percentage of Loans 60 or More Days Delinquent after Modification
Decreased by more than 10%
Decreased by 10% or less
Unchanged
Increased
60.0
50.0
Percent
40.0
30.0
20.0
10.0
0.0
3
4
5
6
7
8
9
Months following modification
Note: Only those loans modified during the first quarter of 2008.
Source: OCC and OTS 2009. Mortgage Metrics Report – Disclosure of National Bank and Federal
Thrift Mortgage Loan Data. Fourth Quarter 2008, April 2009
- 11 -
Significantly, the second most important predictor of mortgage modification success
is the relationship between the borrower and the loan originator. As shown in Figure
11, three months after the loan modification, third-party servicers reported 30.7% of
loans were already seriously delinquent versus only 18.5% of mortgages held directly
Clearly, the strongest predictor of mortgage modifications
success were those with substantial monthly payment
reductions, while those with higher or unchanged payments
performed the worst.
by financial institutions. Six months later, this
proportion jumps to 49.5% of mortgages by
third-party servicers compared to 29.7% that
remain in the real estate portfolios of credit unions, banks, and other retail financial
institutions. This widening gap no doubt reflects different financial terms of
affordability as well as the perverse incentives offered to third-party servicers that
benefit financially from delinquent fees and foreclosure-related expenses.
Figure 11: Percentage of Loans 60 or More Days Delinquent after Modification
On-Book portfolio
Serviced for others
60
50
Percent
40
30
20
10
0
3
4
5
6
7
8
9
Months following modification
Source: OCC and OTS Mortgage Metrics Report – Disclosure of National Bank and Federal Thrift
Mortgage Loan Data. Fourth Quarter 2008, April 2009
- 12 -
Recent Policy Prescriptions
In addition to numerous programs promoted by federal and state agencies in 2007
and 2008 to reduce the number of residential foreclosures,4 in 2009 President Obama
unveiled a robust foreclosure remediation plan entitled the Homeowner
Affordability and Stability (HAS) Plan. This initiative features two distinct programs.
The first program is aimed at the four to five million struggling homeowners with
loans owned or guaranteed by Fannie Mae or Freddie Mac (over one-half of all U.S.
mortgages) to help them refinance their adjustable-rate mortgages (ARMs) into
lower, fixed-rate, traditional 30-year mortgages. Program eligibility is limited to
homeowners whose mortgage loan-to-value is a maximum of 105%. A second
program targets another three to four million homeowners by allowing them to
modify their mortgages to lower monthly interest rates through participating lenders.
Under this plan, the lender voluntarily lowers the interest rate or a combination of
lower interest rates (to a low of 2% APR for a maximum of five years), extends the
payment period (to a maximum of 40 years), and offers partial forbearance of
principal. The U.S. Department of Treasury will provide subsidies of $1000 per year
(for a maximum of three years) to the third-party servicers. Under the HAS program,
servicers are responsible for reducing homeowners’ monthly payments to a
maximum of 38% of their pretax income. After achieving this affordability goal, the
HAS plan matches the amount reduced by the lender to reduce the homeowner's
payments to 31% of pretax income during this reduced payment stabilization period.
These lower payments remain in effect for five years and then reset a maximum of
one interest rate point per year until capping out at the original interest rate.
The Need for a More Aggressive Response
While the Obama HAS plan and recent efforts by the Michigan legislature address
the affordability issues facing many consumers today, both are viewed as a temporary
band-aid to the larger problem of declining real estate asset values. The effective
impact of the Obama plan on the rising number of consumers with negative equity
in their homes is to offer households an adjustable rate mortgage whose price will
4
See Manning 2009 for a discussion on the relative ineffectiveness of these programs.
- 13 -
reset to market values after five years. The major limitation of the HAS plan is that it
does not offer long-run assistance to borrowers who are current on their mortgages
but have a negative equity position in their homes. As stated above, the proportion
of homeowners in a negative equity position is quite large and nearly double the
number who were in that position at the end of 2007 (Armour 2009). Hence, a
significant proportion of homeowners in need of financial assistance are finding the
HAS plan to be of little utility in the long term since it offers virtually no incentive
for servicers to offer principal mortgage reductions. That is, the 30-year, fixed-rate
refinance program is only available to homeowners with mortgages that are not more
than 5% above the current market value of their homes.
The unraveling of the U.S. housing (purchase) and mortgage (investment) markets
has undermined the fragile global financial system, as the international economy has
suddenly fallen into a recession. Countries that were experiencing enormous
economic growth and prosperity due to their own robust housing markets are now
rapidly descending into an economic free fall. Currently, almost everyone involved in
the real estate industry through the construction, purchase, sale, or finance of a
house is experiencing economic distress. Lenders are experiencing unprecedented
levels of foreclosures, loan losses, and challenges to the viability of their institutions.
National and international investors are reporting record losses and are abruptly
withdrawing from primary and secondary real estate markets. Consumers are
experiencing a deteriorating job market, dwindling equity in their homes, and record
levels of household debt that is increasingly difficult to refinance. Regulators are
observing the failure of once healthy financial institutions—including the insolvency
of the nation’s largest commercial banks—and the prospect of new and far-reaching
safety and soundness tools. Finally, policymakers who overlooked the mounting
evidence of impending financial catastrophe are hearing from all of these
constituents that “the situation went terribly out of control, and something has to be
done to solve the crisis immediately.”
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Home Loan Modifications: The Conflicting Interests of
Homeowners and Lenders
The previous section reported on the relative failure of most mortgage modification programs for both
the loan servicer and the homeowner. While the HAS plan obligates servicers of Fannie Mae and
Freddie Mac loans to make mortgages more affordable, portfolio loans and other commercially pooled
servicers are still resistant to participating in the HAS plan due to the modest financial incentives that
have been offered. In particular, some servicers believe that the requirement to monitor and support
borrowers for the five-year duration of the borrower success payments while only receiving success
payments as a servicer for three years is not sufficient. Also, until the net present value calculations are
published, many servicers doubt the value of the program for their own loan portfolios. Servicers are
also anxious to understand what the government intends to do about HELOCs that are in the first lien
position. There are differing opinions as to whether first lien home equity loans are to be included.
Professor Alan M. White of Valparaiso University School of Law presents the problem from a general
viewpoint and clearly explains why it is important to develop a mandatory and aggressive modification
approach:
Mortgage servicers face a classic collective action problem. Each individual servicer, in the face of
declining home values, wants to foreclose on defaulted mortgages as quickly as possible in order
to avoid deepening losses. On the other hand, mortgage servicers and investors as a whole would
maximize returns on defaulted mortgages by halting or slowing the addition of unsold homes to
the inventory to allow demand to reach equilibrium with supply so that homes could be sold at
optimal prices. Moreover, the home price decline contributes to unemployment that produces
more mortgage defaults. No single servicer or group of servicers, however, has any economic
incentive to organize a pause in foreclosures or an organized deleveraging program to benefit the
group. If a single servicer attempts to compromise mortgage debts in order to achieve a better
return than from a foreclosure sale, other servicers who continue foreclosing will benefit
incrementally from the servicer’s forbearance or workout as free riders, because they will sell in a
market with incrementally fewer foreclosed properties. Moreover, the servicer engaged in more
aggressive modifications will face short-run resistance from investors. Reinforcing the collective
action problem are various contractual and legal barriers to renegotiation of mortgage debt
(White, 2009, 4-5).
Indeed, servicers are incentivized to maximize short-term investor value by pursuing foreclosure rather
than offering homeowners more affordable monthly payment options. And, due to the contractual
features of investment grade, asset-backed securities, servicers generally are not permitted to offer
principal reductions to homeowners as a remediation tool—even if it enhances the long-term
performance of the real estate portfolio. Furthermore, due to the perilous financial health of the
banking industry, only the strongest financial institutions are willing to voluntarily write down their real
estate portfolios to market value since doing so has serious negative consequences, such as mandated
higher loan loss reserves, lower capital ratios, and potentially greater regulatory scrutiny. Hence, the vast
majority of Michigan households, whose mortgages have been resold into a variety of pooled
investment securities, have few options in obtaining financial relief through interest rate and especially
principal reductions. The result is a widening gap between falling housing prices and the mortgage
obligations of overleveraged households.
- 15 -
Policy Recommendation for Shared-Equity Loan
Modification Program
As stated earlier, Filene’s 2009 examination of foreclosure mitigation recommended
the development of a standardized shared-equity loan modification program for
financial institutions.
Typically, the goal of public-sector and nonprofit sponsored shared-equity
homeownership programs have focused on increasing affordability for lower- and
middle-income households. The demand for these programs rises during periods of
rapid housing price appreciation and is intended to stabilize local neighborhoods and
communities by increasing homeownership and reducing real estate speculation.
Other shared-equity homeownership programs are designed to reduce income
inequality by improving household asset formation. The objective is to unleash the
transformative power of wealth accumulation through homeownership. Both
approaches seek to overcome or take advantage of the market forces that have
driven recent price surges in urban housing markets (Jacobus 2007).
The current proposal reflects a uniquely different impact of market forces on the
formulation of shared-equity homeownership programs. Although the goal is to
increase the affordability of housing payments, it is implicitly designed to reduce the
gap between falling market values and the debt obligations of homeowners. That is,
to establish a “hard” floor so that consumers are more confident about entering the
real estate market (without suffering further price depreciation), and lenders are more
confident that they are nearing the end of the financial losses in their real estate
portfolio. Indeed, the concern over the current federal government initiatives is that
they offer temporary monthly payment relief that does not reflect the continuing
decline in housing prices. This could have the perverse effect of generalized
consumer disinvestment in the housing stock as homeowners plan to abandon their
homes when the payment relief programs expire and/or housing prices fail to
recover. In addition, while these home ownership affordability programs “buy” time
for the housing market to recover and thus mitigate real and accounting losses to
- 16 -
lenders and investors, they could simply prolong the financial distress of the real
estate industry and postpone the inevitable principal losses until after the 2012
elections. If the residential real estate market does not recover significantly over the
next five years, then it is expected that the housing market will suffer another sharp
decline in five to six years as homeowners leave their poorly maintained houses en
masse.
Development of shared-equity forbearance agreements between loan holders and
mortgagees would mitigate the short-term financial losses arising from voluntary
mortgage modifications that include reductions in principal balances. As soon as a
hard floor is established in the real estate market, then lenders would share in the
future appreciation of housing values arising from the future sale of the principal
residence up to a limit of the debt forbearance. Special attention would be paid to
establishing proper incentives for lenders to participate in these loan modification
programs and to standardizing such programs across all lending and servicing
institutions.
The key to the proposed shared-equity agreement is that it promotes the long-term
stabilization of the housing market by encouraging homeowner commitment to their
homes (increased investment), reduces the supply of houses for sale, and, by
accelerating the establishment of a hard floor, increases consumer confidence that
price appreciation will resume in the near future. With so many potential positive
contributions to the long-term recovery of the real estate market as well as the larger
U.S. economy, it is crucial to develop a shared-equity agreement program that
balances the immediate financial incentives to homeowners with the long-term
financial losses incurred by participating lenders. Specifically, we recommend a
system that provides appropriate incentives for lenders to participate in loan
modification programs that include reductions in outstanding mortgage principal.
Lenders, including federal agencies, will more likely offer and subsidize interest and
principal rate reductions if they can share in any price appreciation of the refinanced
properties when they are sold in the future. This could assume the form of a separate
debt forbearance contract, rather than a debt concession, that could be formalized
through a property lien filed by the lender (including government agencies). This
action would require that an agreed-upon portion of the net capital gains accruing
from the future sale of the residence be distributed to the lien holder up to a
- 17 -
maximum of the agreed-upon mortgage debt forbearance. The overriding objective
is that, if mortgage servicers and lenders are not offered sufficient financial
incentives, then voluntary loan modification programs are unlikely to succeed.
Additionally, lenders are much more likely to participate in loan modification
programs that are standardized (nationally) across geographic regions and classes of
mortgages. This standardization would also contribute to lower transaction costs
associated with establishing a healthy secondary market for the resale of these
modified mortgages, or their components, at a later date.
Shared-Equity Example
For example, if a consumer bought a house in Detroit for $150,000 in 2005 and the
house is appraised at $120,000 in 2009, the homeowner’s negative equity rises to
$30,000. The lender is exposed to a minimum loss of $30,000 plus taxes,
maintenance, and transaction costs following a foreclosure or short sale. The lender
could pursue legal action for the loss but is unlikely to collect a reasonable amount in
this difficult economic environment. A reasonable compromise would be for the
lender to refinance the home into a 30-year, fixed first mortgage of $120,000 (100%
appraised value) plus a second noninterest bearing mortgage/forbearance of $6,000
(20% of debt concession) that is filed as a property lien and due in 10 years. If the
home is not sold during this period, the homeowner could refinance the 20%
forbearance note into the first mortgage or begin a separate interest-accruing
repayment plan. The remaining concession of $24,000 would be negotiated as a
shared-equity agreement with terms that would be contingent on the length of time
of homeownership after the principal reduction. This obligation could be filed as a
lien and would be subordinate to the 20% forbearance note. Upon the sale of the
house, the net proceeds would be shared at a negotiated rate (for example,
50%/50%) beginning with the repayment of the forbearance note and accrued
interest. Any remaining net sale proceeds would be split at a negotiated rate (for
example, 50%/50%), and the lender would receive a share up to the maximum of the
unpaid concession.
With this fixed rate mortgage modification, the combined monthly principal and
interest payments for the homeowner decline from approximately $950 (6.5% ARM
- 18 -
on a $150,000 mortgage) to a much more affordable $670 (5.5% fixed, 30-year
$120,000 mortgage). Ten years later, the home is sold for $165,000 with net proceeds
to the homeowner of $150,000 that immediately repays the outstanding first
mortgage of $98,000. The remaining $52,000 is distributed first to the forbearance
note holder ($6,000), and the balance of $46,000 is shared with the first mortgage
holder ($23,000/$23,000). This results in a net distribution to the homeowner of
$23,000 and a net principal loss to the lender of only $1,000 ($30,000 - $6,000
=$23,000). For the credit union, the previous charge-off of $30,000 would be offset
10 years later by adding $29,000 to its loan loss reserves. If the home sold for
approximately 10% more, with net proceeds of $180,000, then the homeowner
would receive a total of $37,000, while the credit union would offset its earlier loss of
$30,000 with a $30,000 addition to its loan loss reserves. Hence, the homeowner
receives financial incentives for the additional 10-year investment in the home as well
as much more affordable monthly loan payments. Instead of immediately losing
money following the foreclosure or short sale, the commitment to homeownership is
rewarded with an equal share of the net proceeds and even more after the principal
forbearance is repaid.
This shared-equity agreement method is applicable for both private and
nonprofit/governmental agency participants. For instance, the FDIC has proposed
shared-equity programs that would require homeowners to share a portion of the
proceeds from the sale of their homes with the private and government lenders that
absorbed the costs of the interest and principal concessions of their modified loans.
- 19 -
Figure 12: Scenario of Homeowner Selling the House after 5, 10, and 20 Years Later*
5 years later
(2014)
$130,000
10 years later
(2019)
$165,000
20 years later
(2029)
$250,000
Net proceeds
$120,000
$150,000
$235,000
Balance of 1st mortgage
$113,000
$98,000
$56,000
Forbearance
$6,000
$6,000
$6,000 plus %
Shared-equity
$1,000
$46,000
$173,000
$500
$23,000
$24,000
$23,500
$1,000
$0
Sale price
Shared-equity split
Principal FORGIVEN
*Note: Mortgage principle reduced from $150,000 to $120,000 in 20095
Special Considerations for Shared-Equity Loan
Modification Agreements
The key issues for borrowers and lenders is the establishment of a hard floor that
restores confidence in future home purchases with the expectation of reasonable
future appreciation of U.S. housing prices. In the short term, especially with the
preponderance of the U.S. government to assist “upside down” homeowners
through debt service assistance, there are inadequate incentives for credit unions and
other financial institutions to negotiate principal reductions through shared-equity
agreements. Part of the problem is the consequences of a mortgage write-down;
charge-offs and increased loan loss reserves, including reduced capitalization levels
(which are dangerously low for unhealthy financial institutions); and reduced capital
5
A HELOC or other second mortgage on the original, pre-modified mortgage could be offered a
10% forbearance that is subordinate to the first mortgage forbearance. Although technically worthless
if the borrower had negative equity in the home, the lender of the second mortgage could obstruct the
refinance unless offered a financial premium to waive its financial claim. After the 10% second
mortgage forbearance is repaid, it would receive a maximum of 20% more in a 70%/30% split with
the homeowner after the concession of the first mortgage is repaid.
- 20 -
available for profit-generating lending. For healthy institutions, the primary issue is
striking a balance in a debt concession that cannot be repaid in the short term yet
could be repaid in future appreciation if the consumer resides in the home for a long
time. In an effort to achieve a balance of these multiple interests during a period of
continued home price decline, the following shared-equity loan modification plan is
proposed. That is, this plan does not reduce the principal without a potential benefit
to the lender that offered the debt concession while offering a collaborative
partnership with the homeowner to continue to invest and maintain the residence to
ensure future price appreciation.
The success of a loan modification program that features a shared-equity component
is based on two key assumptions: (1) at least moderate appreciation of home values
and (2) commitment of homeowners to remain in their residences and to adequately
maintain them. Mortgage holders that offer interest and principal concessions can
reduce their risk by requiring a financial penalty for selling homes within a specified
period, such as less than three years. Of course, this is a difficult economic period for
collecting financial penalties, and it would be especially burdensome on financially
distressed consumers. Furthermore, lenders will find this option feasible only for
first mortgages that are not encumbered with other liens.
In the short-term, financial institutions will experience continuing losses on their real
estate portfolios. As shown in Figure 12, lenders and investors will not receive
significant financial offsets from shared-equity agreements for at least five years. This
means that real estate write-downs will require increased loan loss reserves that will
reduce already eroded capitalization levels. However, these expected appreciated
gains could offset the expected wave of new defaults that will arise after the HAS
interest rate reductions begin to reset upward in six to seven years.
Because shared-equity agreements will not generate tangible gains until the
homeowner sells the property, credit unions and other financial institutions will be
required to systematically monitor the status of filed shared-equity agreements,
especially after they begin accruing measurable economic value in 5 to 10 years.
- 21 -
Indeed, the major issue is the uncertainty of their value and when these economic
gains will be realized. The exception is the 20% forbearance note that matures in 10
years. Also, there may be cases in which the property can be transferred without
satisfying the shared-equity agreements such as real estate in joint tenancy, where one
party passes away (parent) and the other party (child) assumes the rights of property
ownership. Mortgage holders need to conduct due diligence in recording these
property liens in order to protect the future economic value of these agreements. In
regard to recovering and reporting these future economic gains, lenders will have
already written off the debt concessions and will simply apply these funds to their
loan loss reserves. The accounting and reporting requirements are straightforward
and will not likely entail significant changes in operational policy or procedures for
reporting these realized gains.
Conclusions
The dismal performance of recent mortgage modifications underscores the pressing
need to develop creative approaches for improving the affordability of
homeownership, accelerating the establishment of a hard floor, and enhancing future
recovery of principal write-downs by financial institutions that have suffered from
inflated real estate prices and overleveraged households. Shared-equity agreements
offer a promising approach in achieving these crucially important goals. Indeed,
shared-equity agreements simply entail a negotiated contract between borrower and
lender; with no new required legislative approval through acts of law or new
statutory guidance. Because shared-equity agreements are simple to execute and do
not entail additional financial losses to lenders that would otherwise have to
foreclose or accept a short sale, we encourage policymakers to initiate pilot projects
with selected groups of financial institutions. This approach, moreover, helps to
bridge the modification gap due to the limited options available to homeowners with
under water mortgages. This is the largest and most rapidly growing category of
mortgages that will soon swell the ranks of future home foreclosures. In the process,
these mortgages will not only erode property values in already declining communities
but will further reduce the governmental tax base while imposing greater financial
pressure on mortgage credit markets and financial institutions. With the impending
- 22 -
financial pain of new job losses due to automobile industry layoffs, it is important for
Michigan policymakers to begin piloting innovative approaches to mortgage
modifications. The performance of recent mortgage modifications indicates that the
greatest likelihood of success is attributed to lower monthly payments. For
homeowners with substantial negative equity, the most realistic option for obtaining
a principal reduction is through a negotiated shared-equity agreement as proposed in
this report.
- 23 -
Appendix 1: Legal Considerations
Michigan Credit Union League lawyers found no legal reasoning that “would
prohibit a shared-equity loan modification arrangement” after a thorough legal
review of the following resources:
•
•
•
•
•
The Michigan Credit Union Act.
The Federal Credit Union Act.
The Michigan Mortgage Consumer Protection Act.
NCUA Regulations, Legal Opinion Letters, and Letters to Credit Unions.
Office of Insurance and Financial Regulation Letters and Bulletins.
- 24 -
Appendix 2: Definition of Terms
Debt Concessions: An adjustment in the financial terms of the original loan to the
advantage of the borrower that results in a lower future value of the mortgage. This includes
lower monthly interest rates, debt forbearance, and even principal or accrued interest
forgiveness.
Forbearance: A lender’s deferment of a loan obligation. Typically, mortgage forbearances
are granted to borrowers in order to reduce monthly payments to more affordable levels
based on unexpected household financial distress. The debt concession is postponed (not
forgiven) by, for example, extending a 20-year payment schedule to 30 years.
Loan Modification: Loan modifications typically involve a reduction in the interest rate on
the loan, an extension of the length of the term of the loan, a different type of loan, or any
combination of the three. A lender might be open to modifying a loan because the cost of
doing so is less than the cost of default.
Source: www.answers.com/topic/loan-modification.
Mortgage Principle Reduction: Debt concession to borrower whereby a portion of
principal is forgiven (typically reduced to market value of real estate collateral) in order to
reduce payments to an affordable level. Lenders are most likely to offer this option when
housing prices are falling and net returns of short-sale or foreclosure are low.
Shared-Equity Loan Modification Agreement: A shared-equity is an agreement between
loan holders and mortgagees that limits the financial losses arising from voluntary mortgage
modifications. Lenders share in the capital gains arising from the future sale of the principal
residence up to a limit of the debt forbearance. Special attention is paid to establishing
proper incentives for lenders to participate in these loan modification programs and to
standardizing such programs across all lending and servicing institutions.
Troubled Debt Restructuring: Condition where a lender grants a concession to a
borrower in financial difficulty. The Statement of Financial Accounting Standards No. 15
divides debt restructuring of nonperforming loans, where the loan payments are past due 90
days or more, into two categories: (1) loans where the borrower transfers assets to the lender
and (2) those where credit terms are modified. The latter includes foreclosures, reductions in
the interest rate, extension of the maturity date, and forgiveness of principal and/or interest
payments. Typically, the lender negotiates a workout agreement for the borrower to modify
the original credit terms rather than initiate foreclosure proceedings against the delinquent
borrower.
Source: http://www.answers.com/topic/troubled-debt-restructuring-in-accounting
Under Water Loan: Loan that has gone under its book value because (1) it is
nonperforming (repayments are late or uncertain), (2) its interest rate is below the current
market rate on loans of similar amount and terms, (3) the market value of its collateral has
decreased to less than the amount of the outstanding loan balance, or (4) the collateral is not
the principal source of loan's payment.
Source:www.businessdictionary.com/definition/underwater-loan.html.
- 25 -
Appendix 3: Supplemental Data
Figure 13: Michigan vs. National Subprime Mortgages
Michigan
National
Number of subprime mortgages
113,140
2,650,083
Average interest rate
8.73%
8.26%
$120,814
$181,741
Average loan age (months)
45
42
Average FICO
604
617
Average combined loan-to-value at
origination
Number with interest only
86.72
84.32
7,202
285,275
Number with negative amortization
14
750
% with 30-59 days past due
11.50%
10.50%
% with 60-89 days past due
6.70%
6.00%
% with 90+ days past due
15.30%
13.60%
% in foreclosure
5.50%
11.80%
% originated in 2007
10.50%
15.10%
% originated in 2006
31.40%
36.40%
% originated in or before 2005
58.10%
48.60%
% with no or low documentation
25.70%
32.30%
% ARM loans
71.50%
60.70%
Average initial interest rate
8.37
8.04
Average current interest rate
8.95
8.57
% resetting in next 12 months
9.70%
13.70%
% resetting in 12-23 months
1.80%
3.00%
Average balance
Source: Federal Reserve Bank of New York
- 26 -
Figure 14: Michigan vs. National Alt-A Mortgages
Michigan
National
Number of Alt-A mortgages
52,073
2,139,150
Average interest rate
6.41%
6.29%
$185,138
$321,094
Average loan age (months)
40
37
Average FICO
702
705
Average balance
Average combined loan-to-value at
origination
Number with interest only
85.51
81.15
15,909
586,293
Number with negative amortization
5,982
358,168
% with 30-59 days past due
6.10%
5.60%
% with 60-89 days past due
2.90%
3.40%
% with 90+ days past due
5.40%
7.40%
% in foreclosure
3.40%
7.70%
% originated in 2007
13.60%
21.60%
% originated in 2006
29.90%
35.70%
% originated in or before 2005
56.50%
42.70%
% with no or low documentation
53.90%
73.00%
% ARM loans
44.60%
52.40%
Average initial interest rate
4.93
4.49
Average current interest rate
6.1
6.01
% resetting in next 12 months
8.50%
6.10%
% resetting in 12-23 months
14.00%
9.60%
Source: Federal Reserve Bank of New York
- 27 -
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PUBLICATION #190 (04/09)