Bernanke's Plan Could Work

Fed Chief Bernanke gave the following speech on Tuesday and addressed home foreclosures he deemed "preventable". Here is the portion most talked about:

In cases where refinancing is not possible, the next-best solution may often be some type of loss-mitigation arrangement between the lender and the distressed borrower. Indeed, the Federal Reserve and other regulators have issued guidance urging lenders and servicers to pursue such arrangements as an alternative to foreclosure when feasible and prudent. For the lender or servicer, working out a loan makes economic sense if the net present value [NPV] of the payments under a loss-mitigation strategy exceeds the NPV of payments that would be received in foreclosure. Loss mitigation is made more attractive by the fact that foreclosure costs are often substantial. Historically, the foreclosure process has usually taken from a few months up to a year and a half, depending on state law and whether the borrower files for bankruptcy. The losses to the lender include the missed mortgage payments during that period, taxes, legal and administrative fees, real estate owned [REO] sales commissions, and maintenance expenses. Additional losses arise from the reduction in value associated with repossessed properties, particularly if they are unoccupied for some period.

A recent estimate based on subprime mortgages foreclosed in the fourth quarter of 2007 indicated that total losses exceeded 50 percent of the principal balance, with legal, sales, and maintenance expenses alone amounting to more than 10 percent of principal. With the time period between the last mortgage payment and REO liquidation lengthening in recent months, this loss rate will likely grow even larger. Moreover, as the time to liquidation increases, the uncertainty about the losses increases as well. The low prices offered for subprime-relpurchasing ated securities in secondary markets support the impression that the potential for recovery through foreclosure is limited. The magnitude of, and uncertainty about, expected losses in a foreclosure suggest considerable scope for negotiating a mutually beneficial outcome if the borrower wants to stay in the home.

Could it work?

For example, servicers could accept a principal writedown by an amount at least sufficient to allow the borrower to refinance into a new loan from another source. A writedown that is sufficient to make borrowers eligible for a new loan would remove the downside risk to investors of additional writedowns or a re-default. This arrangement might include a feature that allows the original investors to share in any future appreciation, as recently suggested, for example, by the Office of Thrift Supervision. Servicers could also benefit from greater use of short payoffs, as this approach would simplify the calculation of expected losses and eliminate the future costs and risks of retaining the troubled mortgage in the pool.

What he is suggesting is a modified reverse mortgage on the property. In return for a write-down of current principle or payment modifications, borrowers forgo a percentage of future price appreciation. It is not optimal for either party, but is far better than the choice of foreclosure.

When borrowers were forced to put 20% down to buy a home, the return on foreclosure for the banks was far higher, approaching 80% of the outstanding principle. With 5% down and 0% down in some cases homes, the downside for the banks has jumped dramatically with the return now around 40%. It is no coincidence that these loans make up the majority of current foreclosures. According to Bernake "The worst payment problems have been among subprime adjustable-rate mortgages (subprime ARMs); more than one-fifth of the 3.6 million loans outstanding were seriously delinquent at the end of 2007."

The "Hope Now Alliance" has had successful results to date. Workouts of subprime mortgages rose from around 250,000 in the third quarter of 2007 to 300,000 in the fourth quarter, while workouts of prime mortgages rose from 150,000 to 175,000 over the same period. The pace of workouts picked up a bit more in January.

While initially dismissed by folks who had not read the full speech and rather commented on the headlines, this plan would work. Would it eliminate foreclosures for people way over their heads? No. To be honest, those folks do not deserve to be helped and nor do the lenders that made those loans. There is, however a huge swath of people, who with a little tweaking, not a "bailout", can stay in their homes enabling both parties to win in the long run.

Comments

[liorio1:]

Community/Regional banks will probably go along with this notion as they have roots in their community and that is where their bread and butter is in the long run. On the other hand, "big banks", by their nature, probably will not unless there is a legal directive to do so by the Fed or state regulator. Several reasons for this: bureaucratic inertia, complexity of the portfolio (eg what has already been reserved for - done only on a category basis) and greed (stupidity?) - A monumental bailout, which is already underway with lower interest rates set by the Fed, who else besides the banks are benefitting from them? The sub-prime borrowers? Check the refi fates.

2008 Mar 06 07:53 AM

[Paula Rush:]

It gets very tedious listening to people, including the author of this article who assert they know what will work and won't work. I've spent a thousand hours plus investigating this industry, the practices, and why the lenders, and associated Wall STreet players are NOT MODIFYING LOANS. So, having said that, until you understand the securtized trust, the mortgage insurance on these entire pools, and the credit default swaps, senior and subordinated notes, and other wonders of financial engineering, you should not assert to know what will work. The only thing that is true is the foreclosure costs are rising as borrowers are fighting back in epic numbers, the lenders are having trouble selling the homes they foreclose on, and the MI insurers and credit default swap partners are refusing to pay, accusing the lenders of fraud. Recently Bank of America and TRIAD did this to American Home. However, John Gray, Senior Fraud investigator for EMC/ Bear Stearns has also asserted that it is being discovered loans were "Pledged" in more then one place. So add that possibility into the mix and you begin to get why in many cases loans can't be modified. Loans have even been pledged into CDARS, where a bank gets to borrower money to make loans, the money they borrower is fully FDIC even though it is well over the 100,000 cap, and when all those defaults come down, the S&L crisis will look like a walk in the park. If these same loans were pledged into trust and borrowered against through small banks belonging to this network, then you've got some even bigger issues. So modify loans, that's a joke. Even Paulson said that only 1% of loans are being modified. The dog and pony PR show is about to be unveiled, when the entire financial markets can no longer cover it up. So many borrowers can't be helped, not because the borrower wasn't put in a predatory loan, or because they shouldn't be helped, but because the lenders greed and illegal practices may make it impossible for them to modify loans. The government will have to step in, this is becoming obvious. I believe they will step in by spring or early summer. This topic is much more complicated then what I'm asserting here, and I would need a thousand hours and a book to educate you on these issues. Even Bernake needed a tutorial on the securitized trust. My guess he still doesn't get it. I would just simply like to say, please stop asserting things based on press releases you've read from the industry, or a surface analysis of the situation. Do the research yourself. Dig deeper, or contact me and I would happy to attempt to explain it to you, if you've got a few weeks to spare.

2008 Mar 06 08:30 AM

[Apostle:]

No need to bash the author and assume his knowledge of the topic is superficial. This website is a gathering of opinions of diverse individuals interested in $ and all its wonders and their collective sum is zero, though I still enjoy them for their educational value. Browsing over your blog, no doubt you have done a lot of research probably after getting burned with a bad loan, but you are still no market oracle and all your thousand plus hours of research are still just an opinion will have no more effect on people's actions than a contrary one. So take it easy and enjoy all the views presented here...

2008 Mar 08 05:56 PM

[Todd Sullivan:]

rush.....

notice the title "could work" ?????????
i was commenting on Bernanke's plan, period. your little tirade has nothing to do with the post

2008 Mar 09 07:09 PM