Thursday, February 09, 2012

Mortgage Settlement and Negative Equity

by Bill McBride on 2/09/2012 05:24:00 PM

I don't think the mortgage servicer settlement alone will have a huge impact on housing or the economy, but I do think the settlement will lead to an increase in the number of modifications, and also an increase in the pace of completed foreclosures.

I've seen several people argue the settlement is too small to have much of an impact on housing. They compare the size of the settlement to overall negative equity. As an example from the Financial Times:

The trouble is that the $32bn is small relative to estimates of a $700bn gap between house values and underwater mortgages: it is just 5 per cent of that total.
Note: the $700 billion estimate comes from CoreLogic's Q3 negative equity report.

If we compare the principal reductions to total negative equity, it does seem like a drop in the bucket. However if we think of it terms of a reduction in the number of loans that are 90+ days delinquent and in the foreclosure process, this could be significant.

The FHFA estimates approximately 1 million borrowers will be offered principal reduction modifications, although that estimate may be a little high. Perhaps 500 thousand is a better estimate, and some of them would have received modifications anyway - but the overall number of principal reduction modifications will probably increase by several hundred thousand with the settlement.

Currently, according to LPS, there are 1.79 million loans 90+ days, and 2.07 million in the foreclosure process - or about 3.86 million total seriously delinquent. A few hundred thousand extra modifications would reduce the number of seriously delinquent loans, maybe by 10% (of course some will then re-default).

Also, since there are about 10.7 million borrowers with negative equity, this suggests around 7 million borrowers with negative equity are not seriously delinquent. And that brings us to HARP ...

With the new HARP automated refinancing program coming in March, the borrowers with negative equity and GSE loans will be able to refinance into lower rate mortgages. There borrowers are already current, and if they get a lower mortgage rate (with a faster amortization schedule), they will probably stay current. Not all borrowers with negative equity will eventually default - most won't - and one of the keys to HARP is the shorter amortization schedule that will reduce negative equity fairly quickly. From the FHFA last year:
An important element of these changes is the encouragement, through elimination of certain risk-based fees, for borrowers to utilize HARP to refinance into shorter-term mortgages. Borrowers who owe more on their house than the house is worth will be able to reduce the balance owed much faster if they take advantage of today’s low interest rates by shortening the term of their mortgage.
So I expect the number of borrowers with negative equity to decline fairly quickly over the next several years. This will be combination of modifications, foreclosures and refinancing programs.

Another question is: Will the mortgage settlement lead to a flood of foreclosures? It does appear the number of completed foreclosures will increase following this settlement - especially in some judicial states with large backlogs - so there will probably be more REOs (lender Real Estate Owned) for sale. Some of the REO might be sold in bulk as rentals (REO-to-rental program), and the Fed will probably issue guidance to allow servicers to rent REO in heavily impacted areas. It isn't clear how many more REOs will be on the market, but I don't expect a flood of REO as happened in late 2008 and early 2009.

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