Reprint from Had Enough (soon to be published)
with permission of Ken Gross Copyright 2009
The buzz words of 2009 – “I need a loan mod.” How about this one – “We guaranty we’ll cut your payment in half or we’ll give you your money back.” As in every event of major economic proportion, new businesses emerge in an effort to take advantage of the market conditions. After all – we do have a capitalist system designed to reward creativity with profit. Unfortunately, as is often the case, the floodgates of opportunity often give way to slipshod businesses practices where the dollar is chased by the unscrupulous in exchange for promises that cannot be fulfilled. Such has been the case with the proliferation of loan modification companies and debt settlement companies which employ large national advertising budgets to create the impression of professionalism and competence, but practically speaking offer at best nothing more than exorbitant fees for non attentive and sloppy paper pushing and, at worst, businesses that charge high upfront fees and vanish overnight without providing any service or returning fees for unfulfilled services.
So is there anything legitimate about loan modifications and how is it used as a tool in Financial Crisis Management? The answer is yes – a loan modification is often a valid undertaking and it plays an important role is the FCM. By definition, a loan modification is an agreement between the mortgage holder (normally the lender or mortgage company) and the property owner wherein the repayment terms of the promissory note that is secure by the mortgage are modified in favor of the homeowner to make repayment less burdensome. There are several variables in play here. The most important factor for you to understand is what the range of possible outcomes is and the likelihood of attaining the desired outcome. Will the lender lower my interest rate? Will the lender reduce the principal balance on the loan so that it is consistent with the fair market value of the property as it is today (i.e. the home’s FMV is now less than the principal balance of the loan)? Will the lender forego the payments I have missed and add them onto the back end of the loan? Will the lender extend the mortgage term from the original term? These are all possible outcomes when you seek a loan modification. The key lies in understanding the probability of attaining the specific outcomes.
For starters, you need to know a couple key things. First, there is no magic loan modifier out there. There is no person, company, or guru that exists that can deliver all of these outcomes. The reason is that no loan can be modified unless the lender consents. It is therefore the position of the lender with respect to your particular loan situation that will ultimately control the range of outcomes. The second key is that as of now, lenders are extremely reluctant to reduce the principal balance on the note without regard to the degree that the property’s market value is less than the mortgage balance. This is an unfortunate situation. In fact, a key campaign position taken by the President Obama during the campaign was that he favored allowing bankruptcy judges to have the power to “cramdown” the balance of a first mortgage on residential property down to the fair market value of the property in a Chapter 13 bankruptcy case. Such power is already vested in the bankruptcy judge in the case of real property other than your primary residence. In speech after speech, the President remarked on how inappropriate it was for a bankruptcy judge to have this power in situations involving real estate other than a person’s personal residence and pledged his support to change this law. Unfortunately, after the election, in the midst of the meltdown of Ciitcorp, Merril Lynch, Lehman Brothers, the auto industry and the banking system, all of the economic stimulus initiatives and legislation did not include the bankruptcy cram down provision. The effort made its way through the House of Representatives with the passage of the Homeowners Relief Act of 2009 – but the bill, which included the Cramdown provision sponsored by Senator Chris Dodd of Connecticut, was defeated by a vote in the Senate on April 30, 2009. The defeat was disappointing to those of us who recognized that critical to overcoming the financial hardships caused by the Financial Crisis is creating a valve, where, when appropriate, a homeowner can retain ownership of the home but reduce the mortgage lien on the home so that it is consistent with the FMV of the home. More troubling to me, however, was the way in which the bill went down to defeat. Simply stated, for reasons undisclosed, the Obama Administration abandoned its support of the bill by going “silent” during the critical two weeks during which the bill was a hot topic in Committees and on the Senate floor. In Washington, silence is “death” and that’s precisely what happened to the Cramdown legislation.
What many people do not realize is that the key to the Cramdown legislation was not its use in actual bankruptcy proceedings. The greater good from this bill was that it would have created leverage for homeowners to negotiate with lenders outside of bankruptcy because the homeowner, when speaking through their attorney, could remind the lender that if it did not agree to reduce principal as part of the loan modification, the homeowner would seek the assistance of the bankruptcy judge with his “cramdown” authority. In this situation, the anticipation was that the lender would prefer to avoid the cost of the bankruptcy process as well as the potential write down of the principal balance to current FMV and therefore agree to a compromise by reducing the principal balance so that it was more in line with FMV. The “Cramdown” was thus a leverage tool that could be used in negotiations with the lender in an effort to gain greater concessions, inclusive of principal reductions on the mortgage when the mortgage balance greatly exceeds the market value of the home. The banking industry clearly understood the impact of this legislation outside the bankruptcy process and it’s no surprise that intense objections to the bill and lobbying to kill the bill were advanced by the industry. Unfortunately, the banking industry won. I hope and suspect – you’re not surprised.
So should you take anything away from this short history on the failed cramdown legislation? The answer is “yes.” Leverage is always the key in any negotiation where two parties are attempting to enter into an agreement or restructure an existing agreement. A loan modification is a restructuring of the loan terms between the lender and the homeowner. Though we don’t have the “cramdown tool” to negotiate with the lender, we do have other points that can be made to bolster the argument and persuade the lender that it is in their interest to modify the loan on terms that are acceptable to both sides. The one that is most apparent and persuasive to the lender is the risk and costs that attach to foreclosure of the home. The lender understands that unless a modification is reached, the homeowner will allow the home to proceed to foreclosure. When that occurs, the lender knows that the best it can hope for is to recover the property in approximately 9 months to a year and half, that it will have to bear the costs of repairs to the home to ready it for resale and incur the selling costs of the property and holding costs until sold. The lender ultimately sells the home for FMV or less in a depressed market and its yield for the liquidation of its security is the proceeds of the sale, less all of these costs that it incurred. Though the lender knows this, if you’re negotiating a loan modification, there is no reason not to emphasize these points to the lender.
I’m sure you’re heard about what seems like a zillion different loan modifications programs that the Federal Government and some of the State Governments has adopted in order to streamline the availability of loan modifications for distressed homeowners. In fact, there are several programs and each week new ones are announced and existing ones are modified and changed. To attempt to define them in specific terms here is fruitless because the terms and programs change too rapidly. There are, however, some basic parameters that you should know that provide a road map to the process.
There are two key Federal Programs that provide the genesis for loan modifications in the marketplace. The largest program is the Home Affordable Modication Program, called the “HMP” in loan modification circles. This program applies to mortgages that are not owned or guaranteed by Fannie Mae or Freddie Mac – the two federally supported agencies that combined back millions of mortgage loans in the market. A similar program exists for Fannie Mae and Freddie Mac backed loans as well.
The major loan servicers are participating in the HMP Program. In order to participate, the servicer must sign a Servicer Participation Agreement with Fannie Mae. As a condition of participating, the Servicer is required to consider all “eligible” mortgage loans for modification. At present, Chase, Wells Fargo, Bank of America and virtually all major banks and mortgage lenders are participating in the HMP.
The most critical factor to whether a distressed homeowner can find relief under the HMP is whether the borrower meets the “Eligibility” requirements. If you meet the Eligibility Requirement, then the next test is whether there is a “positive” or “negative” Net Present Value (“NPV”), If the NPV is “positive” a Loan Modification must be offered. If it is negative, it is within the discretion of the Servicer to offer a Loan Modification but it is not mandatory, Even then, if the borrower meets the Eligibility Requirement and the NPV is negative, the HMP provides other Foreclosure Alternatives for borrowers under the HMP.
To be “eligible” under the HMP, the mortgage in question must be a first mortgage given on the property before January 1, 2009. The borrower also cannot have had a previous HMP modification in connection with the same mortgage. The loan must be delinquent or default must be reasonably foreseeable. If foreclosure proceedings have been commenced, then the default requirement is met and foreclosure does not exclude eligibility. The property must be occupied and the borrower must submit a “Hardship Affidavit.” The maximum amount of the unpaid principal balance on the mortgage covering a single unit is $729,750.
So far, these are the relatively easy and inconsequential eligibility requirements. The really big one is next. Your “Monthly Mortgage Payment Ratio” must be greater than 31%. What does this mean? The ratio is your monthly mortgage payment divided by your Gross Monthly Income, multiplied by 100. For example, if your monthly income is $10,000 and your Monthly Mortgage Payment is $3,300, then your Monthly Mortgage Payment Ratio is 33% and you are eligible. (3,300/10,000 = .33 x 100 = 33%). By contrast, if your Monthly Gross Income was $10,000 and your Monthly Mortgage Payment is only $2,800, your MMP Ratio is 28% and you are not eligible.
The Monthly Mortgage Payment includes the monthly interest and principal payment on the first mortgage, plus taxes and insurance, as well as condominium association dues. If these items are not paid with the mortgage payment, they must be annualized and then converted to monthly payments and included in the payment amount. Monthly payments on HELOC, other second and junior liens are not included. “Gross Income” refers to your income before deductions for employee paid benefits, taxes, etc. If self employed, there are criteria established to determine the Monthly Gross Income.
The “Hardship Affidavit” does not impose a problem. The borrower is required to sign an affidavit attesting that they have undergone one or more of the following types of hardship: loss of income, change in household financial circumstances, a recent or upcoming increase in monthly mortgage expense, an increase in other expenses, a lack of sufficient cash reserves to maintain mortgage and living expenses (less than 3 months of covered expenses in savings excluding retirement accounts), excessive monthly debt payments or “other reasons” for hardship. The only other requirement is that if you are “eligible” you must execute a Trial Period Plan by December 31, 2012.
Once “eligibility” has been confirmed. The next critical test is whether the Net Present Value (“NPV”) is “positive” or “negative.” If it is “positive” the Servicer must offer the Loan Modification. The NPV test is a software programmed test devised by the Treasury Department that compares the value of the mortgage to the investor with the mortgage modified compared to the value if not modified. In essence, the present value today of the stream of mortgage payments anticipated if the loan is modified is compared to the net dollars the investor will yield assuming the property is ultimately sold through the foreclosure process. A “positive” NPV means the value is greater if the loan is modified compared to allowing the property to go through the foreclosure process. Even if the NPV is “negative” the Servicer has the discretion under the program to offer a modification.
If the NPV is “positive” the Loan Modification must be offered. At this point, we need to know what the terms of the modification will be here. There is actually a four step process. Step one allows the Servicer to capitalize certain expenses and isn’t really a concern to us. Step two requires the Servicer to reduce the interest rate in increments of 1/8 % (.125) to get the “Target Monthly Mortgage Payment Ratio” to 31%. The floor or maximum that Servicer is required to reduce the interest rate is 2%. If the interest rate reduction does not get the payment ratio to 31%, the next step requires that the term of the mortgage be extended up to 480 months (with interest and payments re-amortized to the new term). If this doesn’t get you to the 31% payment ratio, then the Servicer must forebear on the principal of the loan to the extent necessary to reach the ratio. Forbearance of principal means that portion of the principal is tacked on as a balloon at then end of the term (or when the property is sold) and no interest accrues on the balance.
There is one additional step in the process. The Servicer is also required to verify the Monthly Gross Expenses of the Borrower. The Servicer is required to verify the expense information by running a credit report on the Borrower and calculating expenses. The Servicer is responsible to determine the “Borrowers Total Monthly Debt Ratio (also called the “back-end ratio”). I know what you’re thinking. Not another ratio! Don’t shoot the messenger. This ratio is the Total Monthly Expenses divided by Monthly Gross Income, multiplied by 100 to state as a percent. If the ratio is greater than 55%, the Servicer is required to send the Borrower a “Home Affordable Modification Program Counseling Letter.” The Borrower is then required to work with a HUD approved counselor on a plan to reduce the debt to less than 55%.
A few observations are in order here. First – the entire analysis of whether you qualify for a HMP loan modification is not dependent on your other monthly expenses. The key is whether your Monthly Mortgage Payment is greater than 31% of your Gross Monthly Income. If it is, as long as the NPV is positive then you are eligible for a loan modification. Your other monthly expense obligations do come into play in the NPV calculation because the model makes an assessment on the likelihood of default if the loan is modified. In this instance, too high a debt burden can impact the NPV determination. Planning is therefore an issue of measuring (and sometimes planning) your Gross Monthly Income. There are circumstances where it may be beneficial to postpone increased income in the period preceding an attempted loan modification in order to meet the 31% eligibility requirement.
Naturally, if you’ve experienced a material loss of income, which far too many people have then meeting the eligibility requirement will not be difficult. On the expense side, it is important to attempt to minimize, while being realistic, your other monthly obligations so that you do not adversely cause the risk of default on the modification side to shift the NPR to negative.
If you think about it, this is quite a remarkable program and once it gains full steam, many homeowners will benefit. In the context of the goal of shedding debt, the drawback remains if the unpaid mortgage balance now greatly exceeds the current market value of the home. Another point that should be considered a pro-modification point is the value of the reduced interest rate compared to market rates. If the decision to be made from your standpoint is should I shed the mortgage and seek to acquire an equivalent home at current market value, you need to keep in mind that once you obtain financing for this acquisition, the interest rate you will pay on the new home mortgage will exceed the discounted rate you were able to obtain through the Home Modification Program. On this point, if the disparity between market value and the unpaid mortgage balance is not that significant, then the interest rate differential that favors retaining the existing home may be a financial basis to retain the home. Even here, the shedding of debt should be pursued as to credit card obligations.
The other federal that has garnered more press than it rightfully deserved is the Hope for Homeowners’ Program administered under the Federal Housing Administration (FHA). This program is voluntary from the standpoint of lender participation and provides less benefit that the HMP Program.
Critical to loan modification is meeting the “eligibility” requirements. The bottom line here is that unless your monthly mortgage payment exceeds your monthly gross income by 31%, and in reality, a significant margin beyond 32%, you will not benefit under any of these programs. This means the genesis of the help the Government is providing is to assist those homeowners who have sustained a significant income drop. The only other class that meets the eligibility criteria is a homeowner, who acquired a home with a mortgage that was disproportionately to expensive for their income. There is a very large class of other homeowners who, while not meeting the 31% eligibility parameter, are way underwater in their homes due to the decline in market values. As of July, 2009, according to The Wall Street Journal the average decline in market value of homes in the United States since 2006 is 33%. Many areas, such as Michigan, Arizona, Florida and Las Vegas are far worse.
If you recall, the purpose of reviewing the tools for Financial Crisis Management is to determine which tools have functional utility in specific circumstances. In this context, it is important to understand that Loan Modification will not assist the homeowner whose critical loss in this crisis is the decline in market value of the home. This homeowner, who has income, will not benefit from a loan modification and if he takes no action, he will use his future income to cover the market decline in the home rather than to secure his future retirement.
Loan Modifications, as a tool in Financial Crisis Management, also have a collateral, somewhat sneaky, function. In circumstances where the financial crisis strategy has been determined to require the shedding of the excessive mortgage by allowing the home to proceed through foreclosure, the strategic plan is to allow the homeowner to remain in possession of the home as long as possible in order to allow the homeowner to save money by sparing them the monthly mortgage payment. In this scenario, it is in the homeowner’s interest to allow the process to go as slowly as possible. The process of loan modification takes time. Lenders typically suspend the foreclosure process while the loan modification process is being pursued in earnest by the homeowner. Thus, it can be beneficial to start and complete the loan modification process as a means of delaying the ultimate commencement of foreclosure proceedings. Remember, the goal is to attain your objectives. The lender, of course, will wince at the thought of such a strategy, but we’ll leave the sympathies and such matters for their industry to fess over.
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