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March 4, 2009
By Luke
Mullins
At the heart of the President Barack Obama's
ambitious plan to rescue the housing market is
the conviction that restructuring distressed
mortgages will keep struggling borrowers in
their homes and help insert a floor beneath
plummeting property values. With $75 billion
dedicated to reworking troubled loans, that's a
big bet-especially considering that a top
banking regulator said last December that
almost 53 percent of loans modified in the
first quarter of 2008 went bad again within six
months. But supporters argue that mortgage
modifications need to be properly engineered to
work-and many early ones weren't. To that end,
the Obama administration on Wednesday unveiled
fresh details on its plan to restructure
at-risk loans and help as many as four million
home owners avoid foreclosure. Here are seven
things you need to know about Obama's loan
modification program.
1. Payments, not prices: The plan centers on
the belief that struggling borrowers will stay
in their homes-even as values decline
sharply-as long as they can make their monthly
payments. Although not everyone agrees with
this, billionaire investor Warren Buffett
endorsed the philosophy in his most recent
letter to shareholders. "Commentary about the
current housing crisis often ignores the
crucial fact that most foreclosures do not
occur because a house is worth less than its
mortgage (so-called “upside-down” loans),"
Buffett wrote. "Rather, foreclosures take place
because borrowers can’t pay the monthly payment
that they agreed to pay."
2. Thirty-one percent: To that end, the
administration's plan requires participating
loan servicers to reduce monthly payments to no
more than 38 percent of the borrower's gross
monthly income. The government would then chip
in to bring payments down further, to no more
than 31 percent of the borrower's monthly
income. In lowering the payment, the servicer
would first reduce the interest rate to as low
as 2 percent. If that's not enough to hit the
31 percent threshold, they would then extend
the terms of the loan to up to 40 years. If
that's still not enough, the servicer would
forebear loan principal at no interest. The
plan does not, however, require servicers to
reduce mortgage principal, which Richard Green,
the director of the Lusk Center for Real Estate
at USC, considers a shortcoming. "For
underwater loans, if you don't write down the
balance to be less than the value of the house,
people still have an incentive to default,"
Green says. "Writing down the principal first
instead of last-which is what [the Obama
administration is] proposing-makes sense to
me."
3. Cash incentives: To encourage participation,
servicers will be paid $1,000 for each
modification and will get an additional $1,000
payout each year for as many as three years, as
long as the borrower continues making payments.
Borrowers, meanwhile, can get up to $1,000
knocked off the principal of their loan each
year for as many as five years if they make
their payments on time. Neither party can
receive the cash incentives until the modified
loan payments have been made for at least three
months.
4. Financial hardship: The Obama administration
is pitching its plan as an effort to help
responsible homeowners ensnared in the historic
housing slump and painful recession-not
speculators. As such, only owner-occupied,
primary residences with outstanding principal
balances of up to $729,750 are eligible.
Occupancy status will be verified through
documents, such as the borrower's credit
report. In addition, the program is designed to
target homeowners who are undergoing "serious
hardships"-such as a loss of income-which have
put them at risk of default. To participate,
borrowers will have to sign an affidavit of
financial hardship and verify their income with
documents. "If we would have had such stringent
verification over the last four or five years,
we probably wouldn't be in as bad a position as
we are in," says Richard Moody, the chief
economist at Mission Residential. But while
Moody has no objection to such verification,
obtaining documents from so many homeowners
could be an onerous effort. "It's going to be a
very time-consuming process," he says. Only
loans originated on or before Jan. 1, 2009, are
eligible, and modified payments will remain in
place for five years. Now that the
administration's plan is out, lenders are free
to begin modifying loans.
5. Net present value: To determine if a
particular mortgage will be modified, the
servicer will perform a so-called net present
value test. The test compares the expected cash
flow that the loan would generate if it is
modified with the expected cash flow it would
generate if it isn't. If the modified loan is
expected to produce more cash flow for the
mortgage holder, the servicer is to restructure
the loan. Howard Glaser, a mortgage industry
consultant and a U.S. Department of Housing and
Urban Development official during the Clinton
administration, called this component of the
plan "clever," arguing that it would work to
ensure broad participation. "When you apply the
formula, the loans that are modified are the
ones that are in the best economic interest of
the investors to modify," Glaser says. "The
federal subsidy for the payment on the
modification…tips the scale toward modification
as a better deal for the investor."
6. Second liens: The Obama plan also addresses
the issue of second liens-such as home equity
loans or home equity lines of credit-by
offering incentives to extinguish them. But key
details on this component of the plan remained
unclear. "Distinguishing the second lien is
really important," Green says. "[But] exactly
how they are going to convince the second lien
holder to do this is not clear to me at
all."
7. Will it work? Moody argues that while the
plan may reduce foreclosures for primary
residences, it could lead to a spike in
defaults for another group of homeowners.
Although he supports the administration's
efforts to focus the initiative on primary
residences, Moody notes that "it could be the
case that a lot of [real estate speculators]
have been just hanging on waiting to see
exactly what the details are of this [plan],"
Moody says. Now that it's clear the Obama plan
leaves speculators out, "we could actually see
a spike in foreclosures or at least mortgage
defaults among this group."
Glaser, meanwhile, worries that lenders may
soon be overwhelmed by inquiries from
homeowners looking to participate. "Starting
today, millions of borrowers are going to start
to call their lenders to see whether or not
they are eligible," he said. "And I'm not sure
that the financial services industry has the
capacity to handle these
inquiries."
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