"The Flaws in the FHA Housing Bill"

There is a very good op-ed at the Wall Street Journal today by Adam Levitin, who we have often quoted at the blog Credit Slips. It offers a clear explanation of why the Dodd-Frank housing bill won’t accomplish much in the way of borrower relief. Many of our readers will regard that as a good thing.

However, one has to wonder whether the defects of this bill, which got a good deal of media attention, are a bug or a feature. Normally, I would see a cosmetic law to be a bit of political pandering. Yet Frank is no fool (I withhold judgement on Dodd) and borrower advocates have been quick to criticize the limited results produced by the Bush Administration’s Hope Now Alliance. It would be naive to think that the same won’t happen to this program.

I for one am disappointed at the failure to come up with a solution to the servicer-as-impediment issue. One argument is that borrowers are so underwater they can’t be modded into something viable. Indeed, mods to date have a high reported failure rate.

But my contacts who do borrower counseling tell a different story. The mods being granted are too skimpy and do not even remotely reflect how much the servicer could reduce the balance and still come out markedly ahead for the investors versus a foreclosure scenario. And that isn’t even allowing for damage to the house by angry former owner or due to neglect via a protracted selling process. Historically, it was almost without exception better to keep a borrower in place if they had any abilit to make payments.

So my beef is that it has been assumed that “we can’t interfere with the sanctity of contracts” and find a way to cut the Gordian knot of lack of servicer incentives, staffing, and skill to do mods. Remember, banks are reported to be holding off on foreclosures precisely because they’d rather have a house occupied and maintained, even if the owner can’t pay. That plus increasing unsold inventory says the loss severities on unsold REO (and undeclared REO) is almost certain to be higher than what we have seen recently. And very high loss severities (50%+) means there ought to be some economic win-wins for borrowers and investors compared to foreclosure. But no one seems to have drilled further into the data to see under what circumstances breaking contracts by legislative fiat can be justified as a way to protect and assist investors (admittedly hard to do given the local nature of real estate; one might study a selection of locations to generate decision rules from different conditions).

Remember, the root of the objection to fooling with existing contracts is in fact not any sentimentality about them per se but the concern that if mods were done that hurt investors, it would irrevocably damage the mortgage securitzation market. But what if agreements were breached to create outcomes beneficial to investors?

The problem, of course, is class warfare. Even if you figure out that the investors do better by lowering the principal balance rather than taking the losses and expenses of foreclosure, how do you come up with a formula for reallocating the changed cashflows among the various tranches?

Nevertheless, this line of thinking has not been given the study it deserves, particularly as the housing market seems likely to deteriorate even further. If residential real estate values fall by as much as 40% to 50% nationwide, which the most serious pessimists forecast, trust me, we will see force majeure solutions. It would behoove policy wonks to get out in front of this problem.

From the Wall Street Journal:

One year and one million foreclosures into the mortgage crisis, Congress will finally produce a major piece of legislation aimed at alleviating the problem. The Dodd-Frank FHA Bill will authorize the Federal Housing Administration to insure refinanced mortgages, en masse. FHA-guaranteed mortgage terms will supposedly be more manageable for homeowners than their current ones.

Lawmakers can say they’ve “done something” about the crisis. The only problem is the bill won’t work. Contractual and incentive problems in securitized mortgages will defeat the legislation’s attempt to provide a significant amount of relief.

First, the bill requires lenders to write down the principal on loans by as much as 15%, and waive prepayment fees before their loans are eligible for FHA-guaranteed refinancing. This would be simple enough in the 1950s mortgage market….Today the majority of residential mortgages are held by securitization trusts…

For securitized loans, there is no “lender” who can write down the principal. Instead, management of the loan is contracted out to a servicer. Frequently, servicers are contractually forbidden from modifying loans or else significantly restricted in their ability to do so. This alone will prevent many mortgages from being eligible for FHA refinancing.

Even when servicers can modify loans, they have no incentive to do so for the FHA program. Servicers incur significant costs (up to $1,600) in modifying a loan. Moreover, servicers’ income is mainly based on the amount of principal outstanding in a securitization trust. When a loan leaves the pool because of a refinancing, the servicer ceases to receive revenue from it. Any equity appreciation in the property would be shared by the mortgage holder and the FHA, but not the servicer. In short, servicers have nothing to gain and everything to lose by engaging in the write-downs necessary for the FHA bill to work.

Another obstacle: Many homeowners have second mortgages, and many of these second mortgages are completely “underwater” — or out of money. The second mortgages are frequently held by different entities than the first mortgages. In order for the refinanced mortgage to be insured by FHA, the second mortgage holder would have to be bought out.

Underwater second mortgagees (and many might be underwater even after a write-down on the first mortgage), have nothing to lose by holding out for a high payout and will block many refinancings. The FHA bill does not fix this problem.

Third, the FHA is not staffed to handle hundreds of thousands of refinancings, and neither are mortgage servicers (if they were willing to cooperate). It will take several months for the FHA program to hit full speed. In the meantime, foreclosures will continue, in the hundreds of thousands. The next Congress, in all likelihood, will have to revisit this problem — in 2009.

The final critical flaw is that the FHA bill puts taxpayer dollars at risk.

To the extent that lenders are willing and able to do the write-down necessary for the FHA refinancing, they will only do so for loans that they think are worth less than 85 cents on the dollar. Lenders will retain loans with a higher expected recovery rate. This means there is an adverse selection problem for the FHA refinancing. Lenders will only sell the FHA their worst lemons, so the FHA will be overpaying for bum loans.

Lenders’ contributions to an FHA loss reserve fund, and a special tax on Fannie Mae and Freddie Mac, are supposed to protect against FHA losses. But no one has a firm idea of how many loans will be refinanced or just what the losses will be on those loans. It’s all guesswork, and there’s no reason to think that Congress’s real estate gamble is going to pan out any better than that of so many investors.

Let’s hope Congress gets it right. If not, the taxpayers will be holding the bag, mortgage markets will continue to suffer, and many more families will lose their homes.

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  1. a

    “do not even remotely reflect how much the servicer could reduce the balance and still come out markedly ahead for the investors versus a foreclosure scenario.”

    Yes, but for every mod done, there will be incentive by others who are borderline not to pay their mortgages and to get a mod. Sorry, I think the fairest thing (which is perhaps not the best thing to do in the short-term, but better in the long-) is not to bend over backwards to do mods. Foreclose, rent it to the previous owners, and let everyone get on with it.

  2. Anonymous

    I agree with the previous poster. It is going to be very difficult to draw the border around modifications. If we do get to an extremis (we aren’t there yet), a better way would be to facilitate a process where current “owners” are converted to renters without being forced out of their house would be one way to solve the problem. Plus, it would give them the flexibility to relocate if their job prospects are better elsewhere. This could be a win-win situation for holders of the mortgage paper and the residents without giving a huge incentive for people on the bubble to join in.

  3. Unscripted Thoughts

    “Let’s hope Congress gets it right. If not, the taxpayers will be holding the bag, mortgage markets will continue to suffer, and many more families will lose their homes.”

    Well, we are all screwed then. These economically illiterate bozos have willfully mismanaged the nation’s finances for decades and now they are talking about ‘nationalizing’ entire industries. Fug get a botit.

  4. Anonymous

    “I for one am disappointed at the failure to come up with a solution to the servicer-as-impediment issue”

    HR 5579 tries to address the issue…

    Emergency Mortgage Loan Modification Act of 2008 – Establishes a standard for loan modifications or workout plans for pools of certain residential mortgage loans.
    States that the servicer of such pooled loans owes a duty to the securitization vehicle to maximize recovery of proceeds for the benefit of all investors and holders of beneficial interests in the pooled loans, in the aggregate, and not to any individual party or group of parties.
    Deems the loan servicer to be acting on behalf of the securitization vehicle in the best interest of all such investors and holders if the servicer makes certain loss mitigation efforts for a loan in or facing payment default in the reasonable belief that the particular modification, workout plan, or other mitigation actions will maximize the net present value to be realized over that which would be realized through foreclosure.
    Declares that, absent contractual provisions to the contrary, a servicer acting in a manner consistent with such duty shall not be liable to specified persons (including any person obligated pursuant to a derivatives instrument to make specified payments) for entering into a qualified loan modification or workout plan for loss mitigation purposes.
    Defines “qualified loan modification or workout plan” as one that: (1) is scheduled to remain in place until the borrower sells or refinances the property, or for at least five years from the date of adoption of the plan, whichever is sooner; (2) does not provide for a repayment schedule that results in negative amortization at any time; and (3) does not require the borrower to pay additional points and fees.
    States that, for purposes of a qualified loan modification or workout plan, negative amortization does not include capitalization of delinquent interest and arrearages.
    Defines “securitization vehicle” as a trust, corporation, partnership, limited liability entity, special purpose entity, or other structure that: (1) is the issuer, or is created by the issuer, of mortgage pass-through certificates, participation certificates, mortgage-backed securities, or other similar securities backed by a pool of assets that includes residential mortgage loans; and (2) holds such loans.

  5. Anonymous

    Recently looked at buying a REO home (Northern Calif)which after a month or so of looking and pricing various homes, not to mention looking in the windows of say 50 or more, the wife and I no longer have any interest in that market. Most require extensive rehab and all except new housing, require normal rehab, new floors,heater,roof etc. Pricing of the REO’s while lower does not compensate the buyer for the risk of significant further price decline nor the uncertain fate of the neighborhood in general given the current economic situation.
    Dealing with REO’s realtors and banks asset managers is dificult
    as the realtors have little or no information about the properties and bank asset managers know nothing about the market or home conditions and have a very high turnover rate.
    The idea that somehow these properties can be maintained by folks with economic hardships by allowing them to rent to own or reduce their mortgage balance misses the overall poor condition of these properties and the money necessary to do the property maintenance that will be required to make them liveable. Most of these citizens never understood the need or requirement for home maintenance and do not have the necessary income not only to make the mortgage payment but to keep the home in minimum conditions.

  6. Anonymous

    We are now in a downward spiral – the housing meltdown is causing substantial unemployment which of course means less demand, especially for housing. Investors, especially pension plans with exposure to CDO’s, are bleeding massive money, which significantly adds to demand destruction. Moreover, mortgage rates are still too high. At 6%+ Mortgages are unaffordable for those struggling to survive. On top of that is property taxes which are coming down. Renting is fine but who is going to pay property taxes which the public entities desperately need. The FHA would have to drop mortgage rates to around 4% in order to stimulate any buying.
    The Fed has been tinkering with the economy, but not fixing it. Congress’ attempts also avoid the extreme measures necessary to repair the damage. There is only one solution and that is to make housing affordable. Simply put, Lower prices and mortgage rates (including longer amortization say 60 years). Look at it this way, if you took out a toxic loan in 2005 and your monthly payment was $1,500 plus $500 property taxes, which then escalated to $4,000 (+$500) and you could no longer refinance nor sell your home as it value was less than the principle on you mortgage, then you have default. The FHA remedy, a 15% decrease in principle, doesn’t put a dent in the problem. Lowering the interest rate and stretching the amortization to 60 years does, along with the afore mentioned 15% or more decrease in principle. This is just a rough outline, not a treatise on the mortgage melt down.
    The Fed is taking a shotgun approach to the problem by lowering the Fed funds rate, doing much collateral damage in the process. Congress, Frank-Dodd, is using a rifle to zero in on the forclosure problem, but has missed the mark. A JDAM might do the trick.

  7. Anonymous

    “The Dodd-Frank FHA Bill will authorize the Federal Housing Administration to insure refinanced mortgages, en masse.”

    OMG, between the bailing out Fannie, Freddy, the FHA and the investment banks via the Fed, this country is going to go broke! Investors are going to demand Banana Republic interest rates for their risks. High interest rates and expensive oil are going to kill any true economic growth for the US.

  8. donna

    Absolutely. These weren’t ALL bad loans because of bad borrowers. Many were made into bad loans because of the contract terms. ANd because of the overpricing of the homes, a realistic lender could mod those terms and still come out ahead.

    The real problem was in chasing too high a return by structuring these loans so poorly.

    So what if they have to mod them all? A bad contract is a bad contract, and they SHOULD be modded.

  9. Anonymous


    The problem is simple. Nothing is going to happen from the government until the next administration is seated. Up to then, it’s all free-fall on auto-pilot.

    Think of it as “Hurricane Katrina” for the financial sector. It should be damaging but particularly bad. But it will be very bad because there is no one in the cockpit.

  10. Anonymous

    As this recession deepens, the Fed Gov deficit is going to explode over the next few years:
    -FNM, FRE, FHA, FHLBanks, SLM bond guarantees
    -PBGC pension payments for failing companies-think airlines, GM, F, etc. Ouch
    -Never-ending bail-out bills
    -Never-ending stimulus packages
    -Never-ending war
    -Retiring Fed employees
    -Medicaid for the unemployed
    -Medicaid for nursing homes
    -Medicare and SSN for early retirees who are really unemployable
    -Accelerating FEMA outlays as every thunderstorm is now a Federal disaster

    Interest rates on the Fed debt will someday suddenly rise as everyone sees this explosion while politicians ignore it and make more promises and gov obligations. The Fed debt will suddenly look like sub-prime. The increase in interest payments will supersize the deficit in an upward spiral.

    Goodbye dollar, goodbye savings.

  11. Anonymous

    This bill will put some support under house prices. 85% is just the beginning of the write-down. As others note, second mortgage holders will be out of luck. To come up with the minimum equity, another part may be worked out. FHA will not be a passive accepter of these loans, but will actively vet them, making sure the mortgage borrower has the wherewithal to complete the loan.

    Its model is the Home Owners Loan Corporation, which did a good job in the housing collapse of the Depression, and in fact generated the 30-year fixed mortgage that lasted until this calamity.

    It doesn’t fix everything, by any stretch. But the critical element is to find a bottom for prices, and this is one way to do that. Nor does it expose the government to the obscene risk imagined by some. Far less than the liability of Fannie and Freddie, or even the Fed’s exposure to the investment banks.

    Stiglitz, Roubini, Gross of PIMCO and others have identified it as essential.

  12. Yves Smith

    Anon of 1:29 AM,

    I must beg to differ. First, second mortgages have a secured interest. They can block a refinancing and will demand a payout even if the alternative is to realize zip in foreclosure. That has been discussed here and on other blogs because it is happening.

    Second, the claim that HOLC is a model for now is misleading. HOLC was not created until 1934, AFTER housing prices had collapsed in the US. Here, the objective of these various rescue operations is most assuredly to find a bottom but to prevent one being found. And it that they are destined to be costly failures. Real estate is way out of line, even at its new lower values, with incomes in many markets. You can’t have housing prices systemically above what people can afford to pay.

    Third, the reason HOLC worked is that mortgages in the 1930s required the homeowner to put up a lot of equity (50% or more) and they were pretty short term (five years or so). So HOLC could create a lot of relief by refinancing into newly-invented 30 year mortgages. That lowered payments a lot. And most people stayed in their house their entire life, so the life of the mortgage matched well with their likely occupancy (back then, houses were also often passed to children who lived in them).

    Now average length of home occupancy is much shorter. and there isn’t any trick by which mortgage payments can be reduced. Extending maturities beyond 30 years will have very little impact on monthly payments.

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