Summary

On Friday the administration announced several changes to its basket of homeowner assistance programs.  Although this development generated loud headlines, we think the actual impact will be subtle and, if the history of borrower initiatives of the past three years is a guide, disappointing.  In our view, the most important change is the imposition of mandatory new “outreach” steps in foreclosure proceedings.  This will almost surely have the effect of further slowing foreclosure timelines that are starting to be measured in years, rather than months.  Over time, the new pre-foreclosure requirements may push servicers into performing more short sales.  While the other changes will improve or expand homeowner assistance at the margins, we believe the effects will not be significant.  Bear in mind that with all these assistance programs, you’ve been paid to “bet the unders” in actual volume to date.

Also in this report, we review the latest OCC-OTS figures on loan mod composition and redefault performance.  Though redefault performance overall remains extremely poor, there are signs of hope in the subset of more recent mods that involve significant cuts in monthly payments.

Alternative HAMP Mod Process

Change:  Servicers performing HAMP mods now have to evaluate an alternative approach to the way loans are restructured.  In the standard HAMP process, servicers have to try to get to a 31% DTI, as follows:  first, cut the loan’s rate; second, extend the term; and third, forbear principal.  Under Alt-HAMP the first step will be to forbear principal down to a 115 market LTV; from there, the normal HAMP waterfall of rate cut, term extension and additional principal forbearance occurs.  This change and the principal forgiveness program described below are variations on what BofA announced for Pay-Option and subprime ARMs last week.

Impact:  Tough to call, but this will probably result in an increase in the percentage of HAMP mods that use principal forbearance.  Only 28% of HAMP mods completed to date have used principal forbearance (per MHA monthly report Feb 2010).  An increase from 28% would push CDRs and loss severities incrementally higher where the affected loans are in non-agency securitizations.  However, servicers aren’t required to use the alternative waterfall; they’re simply required to evaluate the projected NPV of Alt-HAMP cash flows and use those whenever that NPV is higher than both regular HAMP and traditional foreclosure-and-liquidation.  What this doesn’t do:  Increase the pool of eligible HAMP borrowers.  This is important, because HAMP completion volumes have been woefully disappointing so far (just 169,000 through Feb 2010).  So it’s not at all clear that Alt-HAMP will affect a large number of loans.  Time frame:  No set date (“later in 2010”).  Remember, this is Washington DC, where the word urgency has a different meaning.

Principal Forgiveness

Change:  Borrowers who remain current on their HAMP-modified loans for 3 years will have the opportunity to turn a portion of principal forbearance into actual forgiveness (down to a 115 market LTV).

Impact:  This could make HAMP mods more attractive to borrowers and push redefault rates down at the margin – depending on the % of troubled borrowers who can distinguish between forbearance and forgiveness.

Beefed-Up Pre-Foreclosure HAMP Outreach

Change:  As noted above, we think this will turn out to be the most important aspect of the new initiatives.  Servicers enlisted in the HAMP program will be required to take additional steps to encourage HAMP-eligible borrowers to seek a loan mod before foreclosing, including:  (1) additional requirements for solicitation of delinquent borrowers, prohibiting the onset of foreclosure proceedings before “reasonable contact efforts” have been made; (2) servicers must stop foreclosure actions once borrowers have entered HAMP mod trials; (3) requires “written certification that a borrower is not HAMP eligible” before a foreclosure sale can be conducted; (4) for borrowers whose mod request was turned down, mandates a 30-day waiting period during which a foreclosure sale is prohibited; (5) requires servicers to evaluate borrowers in bankruptcy for HAMP eligibility.

Impact:  In the near term, this will undoubtedly serve to slow a delinquent loan processing system that’s already bogged-down and overwhelmed with volume.  Over time, if foreclosure becomes too onerous, it’s possible that servicers will opt for more short sales, which is the objective of the new “Home Affordable Foreclosures Alternative” initiative that kicks off Apr 5.  The near-term effect should be good for short credit IOs.  However, a pickup in short sale volume – which is far from certain – would be rough on longer credit IOs, though it could be good for super-seniors if loss severities are kept in-bounds.

New FHA Refinance Option

Change:  A new FHA refi option has been created for underwater conventional loan borrowers.  The new program, which is voluntary for lenders as well as borrowers, is a variation on the FHA Secure program that has been running since 2007.  In this program borrowers refi into a new FHA loan with a 97.75 LTV, based on current home prices.  If the market LTV on the old loan is above 115, the lender must agree to write off principal down to a 115 LTV (subject to a 10% minimum write-down), and accept a second lien for the amount between 97.75 and 115.  Refis in this program require fresh appraisals and standard FHA underwriting, and borrowers must be current on their old loans to qualify.

Impact:  As noted, both borrower and lender must agree to this program.  And this raises the question:  Would any lender choose to take an immediate write-off – and assume a shaky second lien – on a loan that’s still current?  We’re skeptical.  We have seen some speculation that Fannie and Freddie may be bullied into doing this, which would be another death knell for 2005-07 premiums; we’ll see.  Time frame:  Fall 2010 is the target rollout (and these things tend to get behind schedule); watch for a forthcoming FHA Mortgagee Letter for more details.

Increased Incentive Payments for Second Lien Extinguishment

Change:  Incentives for extinguishing second lien principal in the woeful HAMP Second Lien program were roughly doubled, and now range from 6% (i.e., $6 per $100 principal) for very delinquent and very underwater second liens to 21% for loans with market LTVs below 115.

Impact:  The HAMP Second Lien Program has had a very hard time attracting business, with the first participants (BofA, Chase, Wells and Citi) just now coming on board.  The new incentives are big enough to be attention-getting, and the recent sign-ups may indicate that major servicers are finally warming up to the concept of including second liens in HAMP mods.  But many observers believe that the second lien program’s difficulties have little to do with the economics of incentives.  Rather, the problem may be the fact that so many seconds are held on servicers’ books – and those servicers have been reluctant to accept the pain of immediate write-down.  The question now is whether the servicers are finally prepared to absorb the write-downs, ameliorated by a more generous incentive structure.  Again, we’re skeptical.

Increased Incentive Payments for HAFA

Change:  Increased incentive payments in the forthcoming Home Affordable Foreclosure Alternatives program, including those for servicers, borrowers’ moving expenses and second lien holders who agree to extinguishment.

Impact:  HAFA is a big wild card for the mortgage market in 2010-2011.  If the administration can make it sufficiently attractive to short sell – and difficult and unpalatable to foreclose – we could see a big increase in short sale volume, hastening the cleanup of the enormous backlog of seriously delinquent loans.  However, whether servicers can (and are willing to) gear up for large-scale short sales is a question mark.  And if short sale volume does increase, we may test whether the structural advantage of short sales for loss severities can withstand the market price effect of a major burst of supply in troubled real estate markets.

Point of Caution:  Declining HAMP Trial Volume

With the exception of the new FHA refi option, these changes by and large take place within the context of HAMP, and do not materially increase the base of eligible borrowers.  However, the monthly volume of new HAMP trials started has declined sharply since October (see Exhibit 1 below).  We think major servicers were under pressure from the government to show volume early, and picked the low-hanging fruit of obviously eligible borrowers last summer.  Now that well’s starting to run dry.  So Friday’s changes may be improvements to a dying program, with only modest real economic impact.

Modified Loan Performance:  Latest OCC-OTS Data

The latest quarterly OCC-OTS Mortgage Metrics report covers delinquency, loan mod and redefault data from large banks and thrifts servicing 64% of all outstanding first lien mortgages, including both securitized and portfolio loans.  The survey gives an interesting broad-based summary of trends in loan mod structure and performance across sectors.

The Changing Face of Loan Mods

The character of loan mods has shifted substantially under the Obama administration, resulting in significant decreases in borrowers’ monthly payments (Exhibit 2).   For most of 2007-2008 a majority of mods increased monthly payments.  Now, over 80% of all mods – and virtually all HAMP mods – reduce monthly payment.  In 2009 Q4 42% of mods cut payments by more than 20%; the average HAMP mod cut payments by 36%.

Loan mod performance in the era of “reduced payments” has improved substantially, though from an abysmal point of comparison.  2009 Q2-Q3 mods are seeing 15-18% 60+ day delinquencies after 3 months, compared to a 3-month redefault rate of 30-35% from earlier quarters (Exhibit 3).  We believe this is a direct function of the reductions in monthly payments now taking place, though it’s likely that more thoughtful re-underwriting is also playing a role.  One troubling finding is that 2009 Q2’s mods continued to deteriorate in months 4-6; that redefault curve has not flattened-out in the manner of previous quarters’ mods.

Mod Performance:  Payments Matter

The interaction between mod payments and redefaults has been fairly constant for the past year:  When loan mods lower monthly payments, performance improves significantly (Exhibit 4).  We think this factor accounts for most of the improvement in redefault performance from 2009 Q2-Q3 mods, which so far look like a cross between the “10-20% Lower” and “>= 20% Lower” buckets.  Unfortunately, if this similarity continues we’re still looking at a 40-50% redefault rate after one year.

When we view redefault performance by ownership of credit risk (Exhibit 5), a couple of things stand out:  (1) Government loans (primarily FHA/VA) are the worst – the credits were weak to begin with, HAMP is largely unimplemented in this world and FHA rules can be said to encourage mods that are fairly borrower-unfriendly.  (2) Servicers are getting much better performance from mods of their own portfolio loans. The next trend for mods, led by HAMP and Alt-HAMP, will be forbearance or outright forgiveness of principal.  We don’t have any data yet to guide us on the question of whether principal cuts will have the kind of impact that payment cuts are having.  However, we do see that servicers are avidly cutting principal for mods of their own portfolio loans (Exhibit 6) – and we know that they’re getting superior performance overall.

State of the Delinquency Backlog:  Stuck in the Mud

Foreclosures started as a % of the previous quarter’s 90+ day delinquencies continue to decline, setting new lows each quarter (Exhibit 7).  Of course, we see the impact in the backlog of 90+ loans in non-agency RMBS deals, and, less directly, in the huge buyouts from Fannie and Freddie pools that have roiled the passthrough market of late.  How long can this go on?  Will HAFA and short sales finally break the logjam?  Maybe.  But keep in mind that in most securitizations, advances on delinquent loans carry almost no credit risk for servicers, so there's no urgency to clean up the mess.  Advances are, however, non-interest-bearing assets.  That’s not a problem for major servicers now – but it could become one once Fed Funds starts to climb, finally creating a tangible incentive to clear out the backlog.

Point of Caution:  Declining HAMP Trial Volume

With the exception of the new FHA refi option, the latest program changes by and large take place within the context of HAMP, and do not materially increase the base of eligible borrowers.

However, the monthly volume of new HAMP trials started has declined sharply since October.  We think major servicers were under pressure from the government to show volume early, and picked the low-hanging fruit of obviously eligible borrowers last summer.  Now that well’s starting to run dry.

So Friday’s changes may be improvements to a dying program, with only modest real economic impact.

The Changing Face of Loan Mods

The character of loan mods has shifted substantially under the Obama administration, resulting in significant decreases in borrowers’ monthly payments.

For most of 2007-2008 a majority of mods increased monthly payments.  Now, over 80% of all mods – and virtually all HAMP mods – reduce monthly payment.  In 2009 Q4 42% of mods cut payments by more than 20%; the average HAMP mod cut payments by 36%.

Redefault Rates:  Improving, But Still Bad

Loan mod performance in the era of reduced payments has improved substantially, though from an abysmal point of comparison.

2009 Q2-Q3 mods are seeing 15-18% 60+ day delinquencies after 3 months, compared to a 3-month redefault rate of 30-35% from earlier quarters.  We believe this is a direct function of the reductions in monthly payments now taking place, though it’s likely that more thoughtful re-underwriting is also playing a role.

One troubling finding is that 2009 Q2’s mods continued to deteriorate in months 4-6; that redefault curve has not flattened-out in the manner of previous quarters’ mods.

Mod Performance:  Payments Matter

The picture below has been fairly constant for the past year:  When loan mods lower monthly payments, performance improves significantly.

We think this factor accounts for most of the improvement in redefault performance from 2009 Q2-Q3 mods, which so far look like a cross between the “10-20% Lower” and “>= 20% Lower” buckets.  Unfortunately, if this similarity continues we’re still looking at a 40-50% redefault rate after one year.

Who’s Mod Is It?

When we view redefault performance by ownership of credit risk, a couple of things stand out:  (1) Government loans (primarily FHA/VA) are the worst – the credits were weak to begin with, HAMP is largely unimplemented in this world and FHA rules can be said to encourage mods that are fairly borrower-unfriendly.  (2) Servicers are getting much better performance from mods of their own portfolio loans.

Mod of the Future:  Reduced Principal

The next trend for mods, led by HAMP and Alt-HAMP, will be forbearance or outright forgiveness of principal.

We don’t have any data yet to guide us on the question of whether principal cuts will have the kind of impact that payment cuts are having.  However, we do see that servicers are avidly cutting principal for mods of their own portfolio loans – and we know that they’re getting superior performance overall.

State of the Backlog:  Stuck in the Mud

Foreclosures started as a % of the previous quarter’s 90+ day delinquencies continue to decline, setting new lows each quarter.  Of course, we see the impact in the backlog of 90+ loans in non-agency RMBS deals, and, less directly, in the enormous buyouts from Fannie and Freddie pools that have roiled the passthrough market of late.

How long can this go on?  Will HAFA and short sales finally break the logjam?  Perhaps.  But keep in mind that in most securitizations, advances on delinquent loans carry almost no credit risk for servicers, so there's no urgency to clean up the mess.

The advances are, however, non-interest-bearing assets.  That’s not a problem for major servicers now – but it could become one once Fed Funds starts to climb, finally creating a tangible incentive to clear out the backlog.