The Homeowner Affordability and Stability Plan: Potential Benefits and Costs

February 25, 2009

On February 18, 2009, President Obama announced his administration’s plan to prevent home foreclosures in the form of the Homeowner Affordability and Stability Plan. The plan outlines a program that will facilitate the refinancing of mortgages for up to 5 million homeowners. The plan will have a significant impact on banks, both in their roles as lenders and as servicers, as they will play a central role in the refinancings.

The banks’ participation in the mortgage modification program is not mandatory, so to encourage the banks’ involvement the housing plan contains several incentives. The Obama administration has announced that mortgage modification guidelines will be issued in March of this year. These guidelines are only mandatory for banks that accept money from the previously-announced Financial Stability Plan, but all lenders are encouraged to use them. For every mortgage modified according to such guidelines the lender will receive a payment of $1,000. Because a homeowner is less likely to default on a modified mortgage if the modification is made before the homeowner has fallen behind on the original mortgage, lenders will be paid an additional $500 if the modification is made before the initial default occurs. To encourage long-term success in addition to participation, lenders will receive a “pay for success” fee of up to $1,000 per year, for each year that the homeowner stays current on their loan. That payment will be available for the first three years of the modified loan. In addition to payments for individual loan modifications, the government plans to create an insurance fund of up to $10 billion designed to make a monthly insurance payment to banks participating in the program. These payments could be set aside by banks to form a reserve if home prices decline further than expected, creating more defaults than anticipated. These incentives are more extensive than those included in any previous mortgage modification plan.

In addition to the social benefit of homeowner stability, the housing plan may reduce the costs of the housing downturn that banks would otherwise have to bear. On average, foreclosures tend to be more expensive for lenders than modifications. The plan is designed to modify the mortgages of homeowners in danger of foreclosure, but if the expected cost to the bank of modification is greater than the cost of putting a homeowner through foreclosure, then the homeowner will not be eligible under the plan. This will allow banks to avoid the costs of foreclosure, unless it is the cheaper option.

The housing plan could allow banks to avoid the costs of foreclosure and default even on mortgages that are not modified. By keeping more families in their homes, the anticipation is that the decline in value of surrounding properties will be less. It is expected that this will incentivize homeowners to remain current on their mortgage payments rather than walk away from the mortgage because their home equity has been erased by a decline in home value.

Although the housing plan could reduce bank losses in the long term, in the short term the plan could accelerate losses for banks both as lenders and holders of mortgage-backed securities. Because the plan seeks to modify the mortgages of homeowners that are not yet in default, banks must write off losses due to a reduction in collectable interest and principal earlier than if the bank was to wait until foreclosure to account for those losses. Outstanding mortgage-backed securities also face downgrades because the mortgages securing those securities will have less value. The downgrades caused by the modifications may even affect banks that did not participate in originating the modified mortgages due to a decrease in the value of held securities.

Whether losses to banks will be reduced in the long term will depend on mortgages being successfully modified to avoid default. It is uncertain, however, that the planned modifications will ensure a mortgage affordable to homeowners. Once lenders bring the mortgage payment down to 38% of the homeowner’s income, the federal government will further bring the payment down to 31% of income. After five years, however, the loan rate will be reset to the rate in place at the time of the modification. When the rate is stepped up, there is little reason to believe that the homeowner will have the means to afford the payment that they were previously struggling to pay, and the costs of modifying the loan will simply be added to the foreclosure costs. It is possible that the forthcoming modification guidelines will address and provide a solution to this issue. If they do not, the initial savings in foreclosure costs to the banks may be surpassed by the costs of future foreclosures.

The forthcoming modification guidelines may make it easier for banks to meaningfully reduce monthly mortgage payments, thus avoiding future foreclosures. Currently, there is a 55% redefault rate six months after a mortgage modification. One of the contributing factors to this high rate is that more than half of mortgage modifications have left borrowers with the same or higher loan payments. When calculating the monthly payment for a modified mortgage, lenders often add past-due amounts (interest, taxes and insurance) which drive the monthly payment higher than before the modification. Lenders are reluctant to write off these amounts because they face pressure from mortgage investors to avoid losses and there is no safe-harbor provision that will protect lenders from investor lawsuits. Two separate lawsuits have already been filed against banks that have attempted to modify mortgages. The lawsuits allege that modifying mortgages will result in a reduced or delayed flow of funds into certain trusts that issued mortgage-backed securities. Implementing standard modification guidelines may give the banks some protection from investor lawsuits, allowing banks to meaningfully reduce mortgage payments without repercussions.

Whether the Obama administration’s housing plan will ultimately help or hurt banks depends on how many banks choose to participate, the effect of the modifications on mortgage-backed securities and, ultimately, whether the mortgage modification guidelines issued by the administration permit meaningful modifications allowing homeowners to remain in their homes. These mortgage modification programs have both potential costs and benefits to banks which must be carefully considered when deciding whether to implement such a program. Experts in structured finance, tax and litigation should be consulted to better understand the possible ramifications.