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Friday, March 14, 2008

The Frank FHA Refinance Plan

by Tanta on 3/14/2008 10:37:00 AM

Barney Frank has released draft details of a new plan for FHA to insure "short refis," or refinances that involve the old lender accepting less than full payoff. I know you mortgage junkies are on the edge of your seats, so here's the dirt.

A draft proposal of the plan is available here. According to Rep. Frank's website, comments and suggestions are being solicited, so consider yourself encouraged to look it over and let Rep. Frank know what you think.

The proposal is to allow FHA to insure up to $300 billion in refinance "Retention Mortgages" in the next two years that involve lender write-downs of principal ("short refis"). In the context of FHA, $150 billion a year is a very large number: it is nearly double FHA's volume for 2006. In the context of loans that are now or will be underwater in the next two years, it's as little as 10% of distressed mortgage loans. (That depends on whose estimates of price declines you use, and also whose estimates of the eligible borrower universe you choose.) So it's either a deluge or a sizable drop in the bucket; take your pick.

How it works:

1. The new mortgage may have an LTV of no more than 90%, and no subordinate financing (all existing subordinate liens must be extinguished). If I am reading the draft correctly (page 4), the new mortgage LTV includes financed allowable closing costs, as well as the special one-time up-front mortgage insurance premium (UFMIP).

2. All loans require a UFMIP of 5.00% of the new loan amount, in addition to an annual mortgage insurance premium (MIP) of 1.50% (which is added to the interest rate) and the "exit premium" (see below). The 5.00% UFMIP is essentially paid by the old lender in the form of principal write-down.

3. The old mortgage lender must therefore accept payoff proceeds (as "payment in full") that allow the new mortgage amount to be 90%. For example: assume an existing $110 loan on a property with a current valuation of $100. The maximum new loan amount is $90. Out of that $90, $4.50 (5.00% of $90) must be paid to HUD for the up-front insurance premium. Assuming 5.00% in allowable closing costs and prepaid items (escrow funding and per-diem interest), another $4.50 is paid at closing of the new loan. There is therefore $81 left to satisfy the old lender, and so the payoff amount is written down to $81. The old lender's loss is $29 ($110 minus $81, or 26%). Any and all prepayment penalties or fees related to prior delinquency or default must be waived (written off) by the old lender.

4. Some kind of principal reduction of an existing first mortgage is required under this loan program in the draft bill; any refinance that could achieve a 90% LTV without principal reduction of the first mortgage would presumably be processed under a standard FHA program, without the additional premia. It appears, then, that if a current loan had both a first and a second mortgage, with the current LTV of the first being 85-90%, the first mortgage could be refinanced into a standard FHA or FHASecure, with the existing second lien extinguished or subordinated. This would be a better deal for borrowers than the Retention Mortgages, since the MIP would be less expensive (5.00% is a giant UFMIP in FHA terms; the current maximum UFMIP is 1.50-2.25%). Loans fall into the Retention Mortgage bucket when necessary write-offs get to the first lien.

5. When the new loan is originated, HUD gets a second lien that involves no payments or interest. It is designed to recapture an "exit premium" of at least 3.00% of the original mortgage amount, up to as much as 100% of the property appreciation. Upon sale or refinance of the loan, the borrower must pay HUD the greater of 3.00% of the original loan loan amount or a share of appreciation. The appreciation is adjusted for capital improvements (as defined in section 1016 of the IRS code). The shared-appreciation provisions (although not the 3.00% exit premium) phase out after five years, so the amount due is the greater of 3.00% of net proceeds or

100% during the first year
80% during the second year
60% during the third year
40% during the fourth year
20% during the fifth year
0% thereafter

What this appears to mean is that the borrower cannot "cancel" this provision by doing a rate/term refinance of the loan into a conventional mortgage, although it isn't exactly clear to me how the actual calculation works in a refinance. Presumably, a refinance would be treated for calculation purposes like a sale, meaning that the borrower would have to refinance for a high enough loan amount to pay HUD the forgiven principal according to the schedule above.

6. All new mortgages must be fixed rate, and are subject to whatever loan limits are currently in place at the time of refinance. (This draft does not commit to the new higher limits within the two-year period of the program.)

Eligibility for the program is as follows:

7. Owner-occupied principal residences only

8. The borrower must establish lack of capacity to pay existing mortgage or mortgages: the borrower must "certify" that default on existing mortgage has not been "intentional," and must demonstrate that as of March 1, 2008 the borrower's mortgage debt to income ratio on all existing mortgages is greater than 40%.

9. The existing first mortgage must have been originated on or after January 1, 2005 and before July 1, 2007.

10. The mortgage debt ratio must be "meaningfully reduced" from the existing first mortgage. This devil will undoubtedly get worked out in the details of HUD guidelines promulgated to implement this program. It isn't clear to me, for instance, what one would do with an existing interest-only mortgage, which, even with principal reduction, could result in a higher payment, since the new loan must be an amortizing fixed rate loan. The bill clearly requires that the base interest rate on the new loan be a "market rate," but with the 1.50% annual MIP added, the rate on the new loans may be not that far under what a subprime borrower is currently paying. (The draft clearly states that there must be a reduction in debt load in terms of the first mortgage, so elimination of a second lien payment would not "count" here.) The draft mentions that the reduction in payment can come from extending the mortgage term, although I see nothing here specifically authorizing terms on the new mortgage of greater than 35 years (what I believe to be the current limit, although 40 years is in the currently proposed "modernization" bill).

11. Full verification of income is required.

12. The borrower's current FICO, or any prior delinquency of the old loan, is not counted against the borrower in qualifying for the new loan.

13. The new loan may not have a total debt to income (DTI, which includes debt other than the mortgage payment) of more than 40%, if the lender expects immediate endorsement (FHA insurance certification) of the loan. New loans may be made with a DTI of up to 50% or 55%, but in those cases the loan remains uninsured until the first six mortgage payments are made on time. This means that the originating lender holds the default risk on those loans until they have performed for six months.

My thoughts on this so far:

I give points for attempting to balance incentives and protect against abuse. The draft bill does not come right out and limit this explicitly to subprime loans, but in practice it would probably do so, since it limits the program to high-rate existing loans. If the new loan payment has to be an improvement over the old loan payment, and the new loan requires a 1.50% MIP, it would be difficult for a borrower with a prime loan that does not carry private mortgage insurance to be "in the money." Even an existing prime loan with mortgage insurance would probably have a current rate less than the rate offered on these Retention Mortgages. I would still like to see clarification of the maximum loan term allowed here. If the maximum term on the new loan is 40 years, then borrowers with an existing 30-year loan at a relatively lower interest rate may still qualify under the "reduced debt load" guideline.

I hope I am correct about financed closing costs being included in the maximum LTV, since this would have an important impact on preventing "fee loading" on the new originations. That is, the new lender may want to lard the loan up with origination fees, but if those are essentially being paid by the old lender in the form of reduced payoff, then the old lender exerts some counter-pressure on closing costs and fees. (I am simply assuming that eligible borrowers are unlikely to be able to pay their closing costs in cash.) I would like, however, to see an explicit provision in this bill for no premium rate/YSP deals (where the borrower is charged a higher interest rate on the loan, with the "yield spread premium" paid by the wholesaler for the higher-rate loan used to pay closing costs instead of financing them into the loan). It isn't necessarily likely that a premium-rate/YSP deal could work out anyway, given the requirement that the payments on the new loan be lower than the payments on the existing first lien, but it's possible if the rate on the old loan was high enough and market rates in the next two years are low enough. If you remove the possibility of paying closing costs with premium, then you're making the old lender pay them, and that will exert downward pressure on what the new lender will charge. If you don't do that, this can turn into just another fee-extraction opportunity for the slimier mortgage brokers. If HUD allows premium pricing here, it needs to hold the line very firmly on what fees can be charged and put into place strict quality-control measures for making sure that the YSP does not exceed allowable fees.

The shared-appreciation provision seems reasonable enough to me, given that it exempts appreciation due to improvements made by the borrower, which removes a major disincentive of shared-appreciation provisions (the borrower's failure to maintain or improve the property).

I certainly like the idea that lenders wishing to write high-DTI loans have to carry the risk for the first six payments. I suspect we would see, after passage of this, just how much lenders really do believe that high DTIs are sustainable.

As far as HUD's risk, there is certainly always the risk that values will continue to decline, although having 5.00% of the loan amount up front as a loss reserve, in addition to the MIP and the "exit premium," will certainly help. This certainly doesn't seem any riskier to me than HUD's current willingness to insure 97-100% LTV purchase-money loans.

Whether lenders will go for it--or be allowed to go for it--is the real question. The draft bill says that "The Secretary (of HUD) may take such actions as may be necessary and appropriate to facilitate coordination between the holders of the existing senior mortgage and any existing subordinate mortgage to comply with the requirements." It doesn't say what necessary actions might be to force second lien holders to roll over and die--threats? bullying? shunning at cocktail parties?--but that's likely to be a sticking point given current second lien holder behavior. The problem for first lien lenders comes back to the issue of what securitizations do or do not allow. A separate bill is on the table in Congress (Castle-Kanjorski) that gives a legal "safe harbor" to servicers who write down principal on a loan, as long as the net present value of the write-down is greater than the NPV of foreclosing. If that is enacted and clearly applies to short refi payoffs as well as modifications, then it would certainly encourage more servicers of securitized loans to participate.

The final question of how much of that $300 billion could get used in two years is, then, hard to gauge at this point. There are undoubtedly going to be trillions of dollars worth of underwater loans in the next two years, but I'm certainly not convinced that all of them would meet the 40% DTI requirement or, if so, involve borrowers willing to sign that shared-appreciation agreement.

As far as mortgage relief proposals go, this isn't anywhere near as dumb as most. It puts the up-front loss on the existing lender, it is fairly careful to exclude outright speculators, flippers, and abusers, and it limits the outsized-profit potential of the originators of the new loans. It is hardly the dumbest kind of loan FHA insures (see the 97% purchases with "down payment assistance" for the ultimate in dumb). I therefore expect that lenders won't like it much, but perhaps I am just cynical.