Bernanke's Plan Could Work

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by: Todd Sullivan

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.