## How long will you be underwater?, II: Modifications

Part I

So let’s assume that there’s an option value in being above water in your mortgage, if only because you can sell it without having to go into your pocket for additional payments. You’d have to do that for the massive transaction and closing costs in the exercise we are about to do, so we’ll assume that’s even.

I’m curious as to your thoughts, what are some other things that could influence the value of that option?

Mortgage Modification

So…mortgage modification. Through HAMP, the government subsidizes mortgage modifications that get the mortgage payment down to 31% of income. The formula for a fixed-rate mortgage payment is:

c = (r / (1 − (1 + r− N))P0

You can lower “c”, the payment, by reducing the interest rate, increasing the number of years on the loan, and decreasing the principal. And that’s the order of the modification waterfall: taxpayers subsidize lowering the interest to as low as 2%. In order to get the payment down to 31%, the servicers can also increase the terms of the loan out to 40 years, and they can also put principal into forebearance (so you’ll have a balloon payment) or reduce it outright.

From Treasury’s December report, we see that permanent modifications by waterfall steps have 100% interest rate reduction, 43% term extension, and 26% principal forbearance.

So, there’s this family. They are are underwater on their mortgage. They are also stuck in the two-income trap: their current mortgage payment is 40% of their household income, and one of the two equal wage earners loses their job. They can only find new work at half the wage, so their household income is now 75% of what it was a month ago. Their mortgage now goes to 53% of the household budget, and they can’t make ends meet.

So they apply for a modification. There’s two ways this can go to get the mortgage payment down to around 31% of your income. The first is to simply reduce the interest rate to 2%. That looks like this:

Not bad. It decreases the time underwater.

But there’s another way to do the modification. Let’s say the servicer simply reduces the interest rate to 3%. They also add 5% to the principal through fees, taxes, etc. Then, in order to make the mortgage payment fit your budget, they add 8 years to the term of the mortgage, putting you from 27 out of 30 years to 35 out of 35 years. (I think that is how it is done with term extensions, from the Treasury documents I’ve seen).

Your mortgage payment is still the same as in the first example. But that looks like this in this model:

So we know that a shocking 70% of mortgages that are modified have their balances increased. That pushes the curve up in and of itself. I’m currently trying to get numbers on how much it is increased, and how much the terms are increased on average (and interest rate reduced).

Given the nature of servicers in these circumstances, and their current profit incentives, and the clumsiness of regulators and government officials in monitoring their performance, do you think these modifications would go in the good or bad graph? Like that X-Files poster, “I want to believe.” But I’m not seeing anything to convince me. This is a bad way to try and handle this situation.

You know what is good at handling these situations? Bankruptcy courts. Can we get mortgage cramdown already? We can create a special modified bankruptcy rule for mortgage principals if we are worried it would distort all the other consumer spending. You know what else is good at handling these situations? Blunt government dollars. Why don’t we take all the money we are wasting nudging servicers, and just buy the mortgages themselves?

Everything I see here makes me think the government should be going nuts trying to find a solution – this is a serious problem effecting unemployment and the general recovery – and I see little to think HAMP hasn’t been a failure and won’t continue to be.

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### 7 Responses to How long will you be underwater?, II: Modifications

1. bubba says:

Mike, with cramdown, would it be possible/feasible/desirable to also allow some sort of clawback rights for the servicers? For example, allow cramdown to the extent necessary, but, if the mortgagee sells the house within 3 years and receives more than the cramdown-reduced principal the servicer gets 100% of the excess up to the amount of the original loan, within 6 years 75% of the excess, within 9 years 50%, and after 9 years 25% of the excess up to the original reduced principal. This would provide some potential benefit of recoupment for the servicers and provide incentive to the mortgagees to stay in their houses. The rules could also allow the servicers to postpone any write-downs until the loss is definite (i.e. 25% writedown does not take place until after 3 years, and so on).

2. I honestly can’t think of a single legitimate argument against cramdown. The arguments against some other forms of bankruptcy discharge are dumb, but at least they are coherent. Cramdown really is a no brainer.

3. Dan Maceda says:

Why aren’t we buying those mortgages reducing the principal and then selling the reduced mortgage to the processors at the lowest current mortgage rate?Take the hit reduce outstanding CDOs give home owners a break. It’ll reduce real estate taxes because it will force appraisals to value the property realistically but some tax income rather than delinquencies would be better for most communities.

4. Ed says:

I was not previously aware of this issue, but let me tell you I am shocked – shocked – that Obama and the Banking Committee would favor the second option.

5. c smith says:

Why don’t we take all the money we are wasting nudging servicers, and just buy the mortgages themselves?

It’s happening:

Fannie and Freddie announced Wednesday that they will commence accelerated buyouts of 120-day plus delinquent loans from mortgage pools.

6. Ravi says:

Given the economic irrationality of the arguments against cramdown I’m left with one thing: the banks don’t want cramdown because it lets them continue to pretend that hopeless mortgages should be on their books for the original principal value of the loan. Once the loan has been crammed down, even the dimmest auditor would say that it has the crammed down value. However, as long as it hasn’t been crammed down a bank can say I’ve got loans over here and “loan loss reserves” over there and it is very hard to prove their being dishonest (even if they’re consistently under-reserving for loan losses).