Federal Reserve Board: Finance and Economics Discussion Series

Designing Loan Modifications to Address the Mortgage Crisis and the Making Home Affordable Program

ABSTRACT

Delinquencies on residential mortgages and home foreclosures have risen dramatically in the past couple of years. The mortgage losses triggered a broad-based financial crisis and severe recession, which, in turn, exacerbated the initial financial distress faced by homeowners. Although servicers increased their loss mitigation efforts as defaults began to mount, foreclosures continued to occur in cases where both the borrower and investor would be better off if such an outcome were avoided. The U.S. government has engaged in a number of initiatives to reduce such foreclosures. This paper examines the economic underpinnings of the Administration's loan modification program, the Home Affordable Modification Program (HAMP). We argue that HAMP should help many borrowers avoid foreclosure, as its key features - a standardized protocol, incentive fees for servicers, and a requirement that the first lien mortgage payment be reduced to 31 percent of gross income - alleviate some of the previous obstacles to successful modifications. That said, HAMP is not well-suited to address payment problems associated with job loss because the required modification in such cases would often be too costly to qualify for the program. In addition, the focus of the program on reducing the payments associated with the mortgage rather than the principal of the mortgage may limit its effectiveness when the homeowner's equity is sufficiently negative. In this case, recent government efforts to establish a protocol for short sales should be a useful tool in avoiding costly foreclosure.

I. Overview

Large and uncertain credit losses on U.S. mortgages have contributed importantly to the global financial turmoil and economic slump of the past couple of years. As house prices began to fall from their record peaks in mid-2006 and mortgage delinquencies started to climb, the mortgage credit boom seen earlier this decade began to taper off. Conditions in housing finance became progressively worse as house price declines ate into housing equity and lending standards tightened. A subsequent collapse in the value of private mortgage-backed securities and their derivatives severely damaged perceptions about the solvency of financial institutions, which led to broad-based pullbacks in credit availability to each other, and to households and businesses. Delinquencies rose further as reduced spending and production led to job losses. Efforts to shore up the housing market and attenuate the surge in delinquencies (and thus eliminate a major factor in the deterioration of the macroeconomy) were impeded by the inability of mortgage servicers to cope with the scale of the problem. The result has been an unprecedented rise in home foreclosures.

Foreclosures have potentially serious negative economic spillovers, and can be costly not only to households but also to local and broader housing markets. Further, as has been painfully illustrated in recent years, foreclosures may cause outsized damage to the banking system, and, indeed, to credit markets more generally, with far-reaching implications for the functioning of the macroeconomy.

Although servicers increased their loss mitigation efforts as defaults mounted, foreclosures continued to occur in cases where both the borrower and investors would be better off if such an outcome were avoided. As discussed in Cordell, Dynan, Lehnert, Liang, and Mauskopf (2009), the costs of loss mitigation are high and servicers have little financial incentive to invest heavily in the staff and technology to provide these services.1 Moreover, lack of clear guidance about acceptable loan modifications, uncertainty about the success of modifications, conflicting interests of different investors, and the high incidence of junior liens have been important obstacles.

In response to rising foreclosures and servicer constraints, the U.S. government has engaged in a number of initiatives to reduce unnecessary foreclosures. The most comprehensive initiative to date is the Administration's Making Home Affordable (MHA) program, which is part of the Housing Affordability and Stability Plan (HASP) announced in February 2009. This paper examines the economic underpinnings of the loan modifications offered in the Home Affordable Modification Program (HAMP), one of two key MHA sub-programs, with a focus on how HAMP addresses many of the obstacles faced by servicers--in part by using government funds--in their earlier efforts to implement loan modifications.

The paper begins with some background on recent foreclosures and a summary of economic research on the private and social costs of foreclosures. It then discusses why borrowers default and enter foreclosure, why servicers have been slow to pursue alternatives to foreclosure, and it presents some evidence on the rate at which borrowers defaulted on loans modified prior to the introduction of the HAMP. It then describes how the design of HAMP was shaped by these considerations, for example, through the types of modifications provided and through fees paid to servicers, investors, and borrowers. Since loan modifications are only one tool used by policymakers to address the mortgage crisis, we also discuss briefly some other policies to provide attractive refinancing alternatives and lower mortgage rates, including the Home Affordable Refinance Program (HARP), the other key sub-program of MHA, and the latest effort to assist troubled borrowers, a provision for short-sales and deeds-in-lieu of foreclosure.

While servicers were initially slow to sign up for HAMP, 47 servicers covering the majority of eligible mortgages were offering modifications under the program by August 2009. The U.S. Treasury announced in August that the program is on track to reach 3 to 4 million homeowners over the next few years, and, as of early September, more than 570,000 trial modification offers had been extended and about 360,000 trials were started.2 We believe that HAMP`s streamlined and standardized protocol, incentive fees for servicers, and requirement that the first-lien mortgage payment be reduced to at most 31 percent of gross income will alleviate many of the obstacles to successful modifications that have plagued other modification schemes, and thus that the program will help many borrowers avoid foreclosure.

Nonetheless, millions of foreclosures are likely to occur over the next couple of years. House price declines have led to a sharp deterioration in the financial situation of many homeowners, leaving them less willing or able to afford even reduced mortgage payments. Further, HAMP modifications are not well-suited to address many cases where homeowners have suffered a large temporary decline in income, as might be the result of job loss. In particular, because the modification calls for a reduction in the ratio of payments to income based on the current level of income, a reduction that would not be reversed if income were to return to its previous level, the required modification in such cases will often be too costly to qualify the program.

In addition, the program may not be very effective when the value of the mortgage greatly exceeds the value of the home. Some borrowers who believe that there is little prospect for house prices to recover enough to put the mortgage "above water" within some reasonable period of time will not participate in the program and instead walk away from their mortgages. Worse yet, other borrowers may shift beliefs only after entering the program; these borrowers are likely to default after many of the costs associated with the modification have already been borne.

Notwithstanding these shortcomings, the Treasury Department is closely monitoring the progress of HAMP and considering adjustments and extensions. For example, features have recently been added to HAMP that should facilitate short sales and thus help to avoid costly foreclosures. Thus, there is the potential for resources to be redirected as needed to further reduce the costs of foreclosures.