Aug022012

Principal forgiveness with equity recapture: a workable solution for loanowners

Millions of people are underwater on their mortgages, and many of those borrowers have payments straining their ability to pay. The favorite solution of pandering lefties is to simply forgive the debt and lower the borrower’s payments. Of course, the solution would bankrupt the banks and cause significant future problems with moral hazard because borrowers would have a strong incentive to borrow imprudently in hopes of obtaining free money. Principal forgiveness is not the answer, and despite loanowner’s false hope, no significant principal forgiveness is forthcoming.

Excessive mortgage debt is a drain on our economy as too much money is diverted to debt service, but the real problems with loanowners is their immobility. Loanowners are trapped by debt in their homes unable to move to take a better job. This causes resale transaction volumes to suffer which in turn puts less money into the economy through agent commissions and new home sales. The economy struggles due to the existence of the excessive mortgage debt.

Back in April of 2007, I first proposed a workable solution to alleviate the debt problem in the post: How Homedebtors Could Avoid Foreclosure.

As much as it pains me to write this, there is a short to medium term solution to the foreclosure problem: convert part of the mortgage to a zero coupon bond. For those of you not steeped in finance, a zero coupon bond is a bond which does not make periodic interest payments. Think of it a zero amortization loan. You don’t pay either the interest or the principal, and both accumulate for the life of the loan. The loan would be due upon the sale of the house.

Here is how it would work for our typical homedebtor: Assume our financial genius utilized 100% financing and took out a $500,000 interest-only mortgage with a 2% teaser rate that is due to adjust to 6%. Let’s further assume his real income (not what he reported on his liar loan) could support a $1,500 payment on a $250,000 conventional 30-year mortgage at 6%. The bank could convert $250,000 to a conventional mortgage, and convert the other $250,000 to a zero coupon bond at 6% due on sale. The homedebtor can now make their payment, and they get to keep their house. But here is the catch: when they sell their house, they will owe the bank a lot of money. If they sell the house in 20 years, they will owe $800,000 on the zero coupon bond note. In other words, all the equity gain on the value of the home will go to the bank.

This would solve a multitude of problems: First, it would provide a mechanism whereby people who were victims of predatory lending could keep their homes. This would make the homedebtor happy, and it would get government regulators out of the bank’s business. Second, it would make the banks more money in the long run because they are still making their interest profit even if they don’t see it until the homedebtor sells the home (many may not be aware of it, but lenders book income on the increase in principal on a negative amortization loan). Third, since foreclosures would be the primary mechanism facilitating the crash, it would keep home prices from crashing by reducing the number of foreclosures.

Today I want to discuss a similar proposal that’s even more favorable to loanowners. Instead of converting the excessive debt to a zero-coupon second mortgage, make it a zero-interest second mortgage. Basically, you take the “forgiven” debt, freeze it so it doesn’t get larger, and hold it against the property to be recovered by future appreciation similar to the zero-coupon idea described above. Lenders won’t be quite as excited about the idea because they will not be earning interest on their money, but at this point, it’s better to get a return of their capital even if they must sacrifice a return on their capital. This solution also solves some of the other problems I noted with the zero-coupon solution.

The borrowers get to stay in their homes, but they still pay a price. They must give up the appreciation between today’s market value and their original loan balance. Borrowers are no worse off than they are today, and although most would be better off selling and buying a less expensive comparable property so they could keep the appreciation, most won’t do this. Most borrowers will stay in their homes even if they are basically paying an extra 30% to do so.

To really unfreeze the resale market, this zero-interest second must have automatic short sale approval written into the agreement. If the seller wants to get out before the house has appreciated to the point the zero-interest second is no longer underwater, the sale should require no further approval. This wouldn’t have worked years ago, but first mortgage holders are no longer holding up short sales anyway. The existing second mortgage holders are the ones causing problems with short sales today.

Compelling existing second mortgage holders to play along is more problematic. The second mortgages that are currently underwater and delinquent would be delighted to participate in the program. Right now, they have nothing, so if they have the chance to get paid back 10 years from now if the combined mortgage balance is no longer underwater, they are better off than they were today. The second mortgages that are not delinquent is a more difficult sell. As long as the borrowers are paying, second mortgage holders have no reason to participate. These second mortgage holders will benefit from the first mortgage converting part of their principal to a zero-interest loan because the borrower will have greater ability to pay on the still-current second.

Does this idea sound crazy? A senator from Oregon doesn’t think so.

Senator unveils plan to refi 8 million underwater borrowers

By Jon Prior — July 25, 2012 • 11:37am

Sen. Jeff Merkley, D-Ore., submitted a new plan Tuesday for the government to buy up to 8 million underwater mortgages and refinance them into lower rates.

“There is no robust program that enables large numbers of families trapped in high- interest loans across America to refinance,” Merkley writes in a paper detailing the plan. “The lack of such a program hurts our families, our communities, and our economy. That is unacceptable, especially because such a program is entirely feasible.”

The senators proposal would make millions more loans subject to government backing thereby exposing the taxpayer to significant risk of loss.

Merkley describes how a Rebuilding American Homeownership Trust could be built by either the Federal Housing Administration, the Federal Home Loan Banks system or the Federal Reserve. The RAH Trust would sell bonds and use the funds to purchase mortgages from banks, credit unions and originators.

If the federal reserve were to take these loans onto their books, they can always print the money to cover the losses.

Borrowers of these home loans would then be given three choices to refinance within three years.

A homeowner could choose a 4% fixed-interest 15-year mortgage. If the monthly payment were kept the same, the shorter term would allow the borrower to rebuild toward positive equity within three years.

Very few will do this, but it would be the best alternative for holders of the zero-coupon seconds. It isn’t just appreciation that builds equity. Declining loan balances do the same.

A standard 30-year fixed-rate mortgage could be provided as well with lower monthly payments.

Or the borrower could break the 30-year mortgage into a collateralized first mortgage for 95% of the property value and a mostly uncollateralized second mortgage for the balance of the loan.

This is the zero-interest solution I described above. Nearly everyone will chose this option because it has the lowest payment.

The RAH Trust could sell the first mortgage into the private market and structure the uncollateralized part into a “soft second.” No payments would be charged on the soft second and no interest will accrue for five years.

For as much as I don’t like loan modification programs, at least this one doesn’t forgive principal, and it has a chance to really work because the payments will be much more affordable. With the significant equity recapture, the banks get some of their money back, and the borrower has consequences for borrowing too much.

According to the plan, the RAH Trust would profit off the difference between the cost of funds on the bonds and the interest rates charged to borrowers.There would be other rules put in place. No short sales will be considered in the first four years.

This would be necessary to prevent people from strategically short selling. I would drop this requirement to help increase worker mobility. I would allow the short sale, but ding the borrowers credit to provide some consequences.

Borrowers would pay mortgage insurance until they reach an 80% loan-to-value ratio.

Another proposal to get more money into the FHA insurance fund. This is also a good idea.

Eligible borrowers would have to be current on their mortgage. Many of the estimated 11 million underwater homeowners are.

This will piss off many people who were told to default to get a loan modification, but too bad.

Merkley said in the paper there could be other sources of revenue such as the Hardest Hit Fund or money unspent on underwhelming programs of the past.

The Federal Housing Finance Agency recently expanded the Home Affordable Refinance Program, which has swept hundreds of thousands of more Fannie Mae and Freddie Mac borrowers into lower-interest loans. But the boom could slow by September as lenders reach capacity.

Other programs such as HAMP, FHA Short Refi fell short of original estimates, and legislation to provide more refinancing opportunity for underwater borrowers remain stalled in Congress.

“This program is designed to break through many of the obstacles that have bedeviled earlier efforts to fix our housing market,” Merkley writes in the paper. “By utilizing competing lenders, the program would end the voluntary, sole-source system that has bogged down mortgage modifications.”

This idea may gain traction. It’s probably the least bad idea floated so far. All loan modification programs have some amount of moral hazard, and this one does as well; however, with consequences for participation, the moral hazard should be kept to a minimum. It’s certainly better than forgiving principal, and if politicians are intent on doing something, I would rather it be some form of zero-interest second with equity recapture.