Nobody likes remembering the “bad times.” But now that our industry is once again operating close to normal, with loan defaults down and housing prices continuing to trend up, it is easy to forget the painful lessons of the not-so-distant past. However, if we do, history is likely to repeat itself.
We are already starting to see a return of some of the risky and questionable decisions made in the early 2000s. For example, because rising home prices in many markets are creating “affordability” pressures, particularly for first-time buyers, once again, our industry is responding with “affordability” products.
While some of these products may not be as risky as pay-option adjustable-rate mortgages or subprime loans that reset in two years, earlier this year, one California lender began offering 120% loan-to-value (LTV) loans that roll up student and mortgage debt. Meanwhile, a large national mortgage bank is offering 1% down mortgages, and Fannie Mae, Freddie Mac, and the U.S. Department of Housing and Urban Development (HUD)/Federal Housing Agency (FHA) have reintroduced 3% down loan programs.
It’s true that the industry has much tighter verification and underwriting standards than in the go-go days of 2006 and 2007. However, like then, loan performance statistics continue to show that high-LTV loans have a significantly greater likelihood of going into default. If the credit box widens and lenders reach for volume increases, a certain number of loans reasonably could go into default.
Will we be ready this time?
The servicing industry was not ready for the mortgage crisis, otherwise known as the Great Recession of 2008. One of the biggest reasons was a lack of consistent, effective loss mitigation and loan modification options.
Effective loss mitigation strategies, specifically effective loan modification options, are an important approach to help offset the default risks associated with high-LTV buyers. As the recent housing crisis taught us, loan modification options must appreciate the needs of borrowers, as well as mortgage servicers, and to be most effective, they must be re-evaluated from time to time to meet the changing risks in the housing market.
Through the Home Affordability Modification Program (HAMP), the industry received a new standardized and practical approach to loan modification. HAMP established standard review timelines and payment terms that could be applied to different investors and appreciated loan affordability after default in a way not previously appreciated.
On that note, one of the reasons why HAMP was effective was that it did not try to guess the right amount, in terms of dollars and cents, to reduce a borrower’s loan payment. Instead, it tied payment reductions to a percentage of the borrowers’ gross income: 31%. Over time, this more holistic approach outperformed other loan modification options and resulted in more reperforming loans and significantly fewer redefaults.
Other market factors likely also contributed to the success of HAMP, and those factors should not be overlooked. However, by setting the repayment term as a piece of the borrowers’ overall monthly budget as HAMP did, borrowers had a more genuine relationship to their mortgage, which set up borrowers to be more successful in repayment.
We worked with one of the nation’s largest servicers to create and close the first HAMP modification in 2009. Since then, more than 1.5 million HAMP modifications have been completed. Now that HAMP has expired, the industry is facing the question of what will replace it.
The U.S. Department of the Treasury, the Federal Housing Finance Agency and HUD – a.k.a., the agencies – have encouraged the industry to apply five key principles to any new loan modification programs:
- Transparency; and
While all of these principles are significant, for a loan modification to be a true alternative to foreclosure, affordability and sustainability are the most critical. To meet these principles (and to its credit), the FHA has decided that it will continue to use the HAMP approach in its loss mitigation efforts.
Fannie Mae and Freddie Mac, however, have decided to take a different approach through the Flex Modification program. Flex Mod includes important elements of the HAMP program, with one major exception: It uses a straight dollars-and-cents reduction approach, similar to the programs that underperformed in the early days of the foreclosure crisis. By not using a percentage of gross income approach, borrowers are, on average, 10% less likely to succeed in making long-term payments, according to Fannie Mae’s statistics.
Given that a key indicator of redefault after a loan modification is insufficient loan-payment reduction, the government-sponsored enterprises should reconsider the Flex Mod repayment structure to ensure that servicers are ready when, not if, there’s another economic downturn and the next generation of high-LTV loans begin to default.
One important approach the mortgage industry should consider is making a HAMP-like program a permanent option. Due to its focus on affordability, no other loan modification program proved as successful as HAMP in the housing crisis. While it may not be the perfect solution if mortgage lenders do not have a similar option to HAMP to mitigate the risk that the new first-time home buyers present, the housing market could see an unmanageable spike in mortgage foreclosures.
Mortgage lending will always be inherently risky and uncertain due to the wide variety of economic factors at play. While the current market is healthier than it was a decade ago, it is still necessary to be able to provide loan modification programs that can truly provide an affordable – and, therefore, sustainable – alternative to foreclosure.
Unless the mortgage industry is willing to accept the fact that the HAMP approach should be the new normal for loan modifications, history could be destined to repeat itself.
Tim Burchard is managing regulatory counsel at LenderLive, a service provider to the mortgage industry. Burchard’s expertise extends to knowledge of GSE, FHA and VA requirements, as well as TILA, RESPA, FCRA, FDCPA and SCRA.