Compliance Article
02/15/2008
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Introduction
It should come as no surprise to anyone reading this article that the mortgage market is in a bit of a slump. In fact, many would say that America is in the midst of a mortgage “crisis.” With new Housing Starts having taken a precipitous fall while the number of delinquent mortgages and homes in foreclosure are at record levels, there is great concern about the state of the residential lending market across the board – from borrowers to lenders and investors to the government.
As mortgage professionals, we are not only concerned with the poor performance of certain types of subprime loans, but we are interested in ensuring that the residential lending market remains healthy and robust. While Congress and the states clamor for solutions that will benefit everyone involved, there are solutions that lenders can begin to use now to help mitigate loss. Loan modifications are an alternative that might just be a win for everyone involved.
A Brief History of Subprime ARMs
With the housing boom of the early 2000s came the development of subprime hybrid adjustable rate mortgages (ARMs). Loan products offering low introductory interest rates, typically for two or three years, which would then adjust to a much higher rate came into vogue. During this time, lenders also began promoting low- or no-income documentation loans to help borrowers with good credit, who might not be able to properly document their income, obtain mortgage loans.
Both hybrid ARMs and no-documentation loans are very useful tools in the proper circumstances. For example, a doctor finishing his last two years of residency might have somewhat limited income, with the promise of substantially greater earnings once he enters private practice in two years. For such a borrower a 2/28 ARM (one which has a low introductory rate for the first two years, followed by a higher rate for the remainder of the loan term) makes good sense. The doctor could then refinance his mortgage into a conventional fixed-rate loan when his earnings reached a point where he could afford the refinance.
But these products come with a downside as well. They permit borrowers to qualify for loans which they might not be able to repay at the full contract rate. Take the hybrid ARMs, for example. According to many legislators, these are at the root of the problem. Many lenders began making these loans with the intention of refinancing the borrower before the loan reset. The problem with this plan is that property values have been decreasing in recent years and now that these loans have begun to reset, borrowers do not have sufficient equity in their homes to refinance the loans. Now those borrowers face the reality of repaying their loans at dramatically higher interest rates that they cannot possibly afford.
To be certain, many lenders have been using these tools in the manner in which they were intended. But there have also been opportunists in the market who have used these as short-term tools to make, and churn out, loans that are not in the best interest of the borrowers. Now that the loans are resetting to interest rates which the borrowers cannot afford, the entire mortgage market is paying the price.
According to the Mortgage Bankers Association’s National Delinquency Survey Q307, the rate of subprime ARMs in delinquency or foreclosure had reached 15.6%, which was more than double the rate from one year prior. There is approximately $526 billion of mortgage debt from these products currently outstanding, according to FDIC Quarterly, The Case For Loan Modification (2007). Nearly 100,000 of these loans are resetting each month, which suggests that delinquency rates could reach an even higher level in the coming months.
It is clear that lenders and investors need to find a way to mitigate the losses that heavy delinquencies and foreclosures represent. The cost, and length of time, represented by foreclosure causes a substantial drain on lender and investor resources, and makes it difficult for them to hope to recapture those losses in full. Loan modifications provide a means by which lenders and investors might, at least, mitigate some of those losses.
Why Do Loan Modifications Make Sense?
Loan modifications have been available for years, but it is the recent rise in delinquencies and foreclosures which has brought them to the forefront of the public eye. Loan modifications permit lenders to restructure loans in a manner that makes it possible for borrowers to resume timely payments on the mortgages without having to institute foreclosure proceedings.
Some of the loan modifications variations include:
- Modifying to a fixed interest rate
- Modifying to extend the loan term
- Modifying to extend the fixed rate period of an adjustable rate loan
These options provide solutions to help lenders find a way to restructure existing loans which are currently delinquent, or in danger of becoming delinquent, to permit the borrowers to continue making timely payments. Any delinquent amounts, including late charges and interest penalties, can be rolled into the newly modified loan, further mitigating their losses.
Many lenders are concerned about the notion that loan modifications might provide a windfall for subprime borrowers and deny investors their expected returns. The FDIC article, The Case for Loan Modification, addresses these concerns by explaining borrowers will still be paying subprime rates after restructuring, which were comparable to the weighted-average of subprime fixed-rate loans made at the same time as the hybrid ARMs being modified.
Investors’ concerns are also unfounded because very few hybrid borrowers stay in the investor’s loan pool and pay the full contract interest rate after reset – approximately one in 30. And loans that go into foreclosure may expect to accrue costs that can be as high as half the value of the property (Id.). Loan modifications make sense for lenders and investors because they can help them avoid costly foreclosures and let them retain good performing loans in the loan pools at a relatively low cost.
While there are many possible solutions being bandied about in Congress and in state legislatures, there is no question that foreclosures are bad for business and for the economy in general. Borrowers going into foreclosure are less able to obtain financing on future mortgages, thereby decreasing the pool of prime borrowers in the future. After a foreclosure, the lender and investor cannot hope to recover any more return on their investment, and often suffer a substantial loss, if the home is not adequately collateralized.
Foreclosures and delinquencies also have a draining effect on the public’s confidence in the industry and the economy. This can have a long-term effect on prospective borrowers’ willingness to refinance or purchase new homes. All in all, a solution which enables lenders to restructure loans to recapture a greater portion of their investment while helping to restore borrowers’ confidence in the lenders and in the economy is a win for everyone involved. Loan modifications address many of these concerns and are available immediately for lenders to utilize.
Conclusion
The mortgage crisis in America has garnered significant attention both within the industry and in the general media. While there remains much uncertainty about what the future holds for the industry with respect to regulation and legislation, there is something lenders can do right now to help mitigate some of their losses and to help benefit the industry in general.
Loan modifications provide varying degrees of payment relief to over-extended borrowers by either lowering their monthly mortgage payments or ensuring that their current mortgage payments will not increase due to a rate reset. Loan modifications also provide lenders with something of a “lifeline” they can extend to borrowers to help them stay current with their loans and prevent foreclosures, which are costly to borrowers, lenders, and investors alike.
While the country is searching for a means to help stem the rates of delinquency and foreclosure in mortgages, there is a ready-made alternative that might solve everyone’s problems. Loan modifications may not be the end-all be-all in solutions, but they are certainly an alternative that has enough upside to be given serious consideration in many situations. And who knows? Maybe they can be a win-win for everyone involved.
