Thursday, May 01, 2008

HOP Is Not A Plan

by Tanta on 5/01/2008 11:55:00 AM

I think the British term "scheme" might apply, however.

And what, you ask, is HOP? It is the brainchild of the only Federal Deposit Insurance Corporation you happen to have, that's what. Formally, it is the Home Ownership Preservation Loan:

This proposal is designed to result in no cost to the government:

* Borrowers must repay their restructured mortgage and the HOP loan.
* To enter the program, mortgage investors pay Treasury's financing costs and agree to concessions on the underlying mortgage to achieve an affordable payment.
* Treasury would have a super-priority interest -- superior to mortgage investors' interest -- to guarantee repayment. If the borrower defaulted, refinanced or sold the property, Treasury would have a priority recovery for the amount of its loan from any proceeds.
* The government has no continued obligation and the loans are repaid in full.

Mortgage Restructuring:

* Eligible, unaffordable mortgages would be paid down by up to 20 percent and restructured into fully-amortized, fixed rate loans for the balance of the original loan term at the lower balance. New interest rate capped at Freddie Mac 30-year fixed rate.
* Restructured mortgages cannot exceed a debt-to-income ratio for all housing-related expenses greater than 35 percent of the borrower's verified current gross income ('front-end DTI').
* Prepayment penalties, deferred interest, or negative amortization are barred.
* Mortgage investors would pay the first five years of interest due to Treasury on the HOP loans when they enter the program. After 5 years, borrowers would begin repaying the HOP loan at fixed Treasury rates.
* Servicers would agree to periodic special audits by a federal banking agency.

Process:

* Mortgage investors would apply to Treasury for funds and would be responsible for complying with the terms for the HOP loans, restructuring mortgages, and subordinating their interest to Treasury.
* Administratively simple. Eligibility is determined by origination documentation and restructuring is based on verified current income and restructured mortgage payments.

Funding:

* A Treasury public debt offering of $50 billion would be sufficient to fund modifications of approximately 1 million loans that were "unsustainable at origination." Principal and interest costs are fully repaid.

Eligible Mortgages:

Applies only to mortgages for owner-occupied residences that are:

* Unaffordable – defined by front-end DTIs exceeding 40 percent at origination.
* Below the FHA conforming loan limit.
* Originated between January 1, 2003 and June 30, 2007.
The FDIC helpfully gives us an example of a $200,000 2/28 loan with 28 years remaining to maturity at a fully-indexed rate of 8.00%. Using the payment provided for the HOP loan of $235 ($40,000 repaid over 23 years, as the first five years require no payment from the borrower), the assumed interest rate is 4.6% or roughly the yield on the 30-year Treasury bond.

So all the investor would have to do is apply for $40,000 in Treasury funds. I have to assume that the first five years of interest to the Treasury is prepaid by the investor, meaning the actual funding would be $30,800 (4.6% interest for five years of $9,200 subtracted from the funding amount). For a securitized mortgage, this would be an immediate charge to the deal's credit enhancement (presumably a write-down to the overcollateralization or most subordinate bond, possibly a partial claim against a mortgage insurance policy). I find it hard to believe that the Treasury would contemplate having mortgage-backed securities remitting monthly interest to the Treasury for five years. But then, I find a lot hard to believe these days, and the FDIC website doesn't really say.

The interest rate on the loan would be reduced to 5.88% for the remaining 28 years. The difference between the fully-indexed rate of 8% and the modified rate of 5.88%, adjusted for whatever anybody happens to think is a plausible average prepayment speed for a loan like this, would be a reduction to the "excess spread" or overcollateralization of the security.

The servicer would execute a modification of mortgage which would adjust the terms accordingly, and record that modification in a junior position to the mortgage given to the Treasury. So, assuming the value of the property was $200,000 at the time, instead of an "80/20" deal this would be a "20/80" deal. In the case of subsequent sale of the home (or default), the Treasury's $40,000 loan would be satisfied first, before any funds were available to the holder of the $160,000 "second lien." (Presumably, if there were a sale or default within the first five years, a portion of the prepaid interest could be deducted from the payoff of the Treasury's lien.)

If, on the other hand, the loan performed for five years and then the borrower sold the property for, say, $220,000, the Treasury would get $40,000, the investor would be paid the outstanding balance on the $160,000 loan (about $147,000), and the borrower would receive the rest of the proceeds. I don't see any provision for the lender to recover the interest it paid on the Treasury loan ($9,200) at this point. As far as I can tell there is no "equity sharing" arrangement on these loans.

What happens if there is lender-paid or borrower-paid MI on the loan? I have no idea. Possibly the mortgage insurer might agree to pay a partial claim when the loan is modified (to cover the investor's loss of the prepaid interest on the Treasury loan), and then the policy would be modified so that the new insured amount is equal to the reduced loan balance (in exchange for a reduced premium). That would reduce the MI's absolute loss exposure in dollar terms. (Suppose the MI coverage on the loan is 35%; the MI's dollar exposure would be $70,000 on $200,000 but only $56,000 on $160,000.) I really have no idea, although I'm sure that insured loans are a small fraction of the loans the FDIC has in mind here.

More likely they have outstanding second liens, and apparently what's supposed to happen here is that the second lien lender just writes off its entire loan amount and goes away quietly. There is only one rather stark sentence regarding second liens: "Under the proposal, the underlying loan is modified within the mortgage pool and does not worsen the position of subordinate lien holders." I gather that means that the second lien lenders are expected to subordinate their liens behind the old first-lien lender's new second lien, making the second a third. (To release the second lien entirely would surely have to be understood to "worsen" the second lienholder's position here.) There is no discussion of the possibility of using the Treasury loan to pay off or pay down the second lien, only to pay down the first lien. HOP may not worsen the second lienholder's position, but it doesn't improve it any.

In the FDIC example loan, the borrower's housing payment-to-income ratio goes from 50% at the time of modification to 35% for five years, and then increases to 39% for the remainder of the loan. These numbers already have a 1.5% annual income increase built into them. If the borrowers have no other debt, that's certainly affordable. Is it affordable enough that the reduced frequency of default in the next five years or so makes up for the increased severity of loss given default to the investor? A borrower whose HTI was 50% and whose DTI was 60% will be going to an HTI of 35% and a DTI of 45%. With the distinct possibility of further declines in home values, that's still a pretty high-risk loan. I'm guessing we will be able to judge whether investors think so by the extent to which they all line right up to participate in this voluntary program. Of course, servicers will be looking at the total debt-to-income ratio, not just the housing payment.

Bottom line: although it's silly to claim this program will have no cost to the government, it is true that the government's exposure is minimal (administrative expenses; either the Treasury services its own loan or the servicer is being asked to do so for free), assuming that I am correct that the first five years' interest will be prepaid. The losses are taken by the lenders and the borrower pays back the full loan amount, albeit at a reduced interest rate. As far as I can tell, the only party who really gets a "bailout" here is the mortgage insurers. That's the real beauty of this plan, and why I cannot for a moment imagine it's going to work.

If you made the assumption that borrowers are entirely insensitive to their equity position--that it is only a question of making the monthly payment affordable--then you could assume that borrowers would like this program and that it would substantially prevent defaults. If you do assume that equity position matters as well as affordability, then this program doesn't do much, since it doesn't change the total indebtedness--even if second lienholders are charging off their loans, if they aren't releasing their liens that money can still be collected from future sale proceeds. Having those liens still out there is likely to make voluntary sale of the property unlikely for some time to come, given the house price outlook.

And the key is a real reduction in the likelihood of default, since it's clear that in the event of default the lender is worse off under the HOP scheme than it would otherwise have been. We can certainly applaud the FDIC for coming up with a plan that protects the taxpayers' contribution in any scenario, but I'm not sure that MBS servicers (or even portfolio lenders) will see this as a sufficient improvement to the risk of default on these loans to take the bait.