At the heart of the President Barack Obama's ambitious plan to rescue the housing market is the conviction that restructuring distressed mortgages will keep struggling borrowers in their homes and help insert a floor beneath plummeting property values. With $75 billion dedicated to reworking troubled loans, that's a big bet—especially considering that a top banking regulator said last December that almost 53 percent of loans modified in the first quarter of 2008 went bad again within six months. But supporters argue that mortgage modifications need to be properly engineered to work—and many early ones weren't. To that end, the Obama administration on Wednesday unveiled fresh details on its plan to restructure at-risk loans and help as many as four million home owners avoid foreclosure. Here are seven things you need to know about Obama's loan modification program.
1. Payments, not prices: The plan centers on the belief that struggling borrowers will stay in their homes—even as values decline sharply—as long as they can make their monthly payments. Although not everyone agrees with this, billionaire investor Warren Buffett endorsed the philosophy in his most recent letter to shareholders. "Commentary about the current housing crisis often ignores the crucial fact that most foreclosures do not occur because a house is worth less than its mortgage (so-called “upside-down” loans)," Buffett wrote. "Rather, foreclosures take place because borrowers can’t pay the monthly payment that they agreed to pay."
2. Thirty-one percent: To that end, the administration's plan requires participating loan servicers to reduce monthly payments to no more than 38 percent of the borrower's gross monthly income. The government would then chip in to bring payments down further, to no more than 31 percent of the borrower's monthly income. In lowering the payment, the servicer would first reduce the interest rate to as low as 2 percent. If that's not enough to hit the 31 percent threshold, they would then extend the terms of the loan to up to 40 years. If that's still not enough, the servicer would forebear loan principal at no interest. The plan does not, however, require servicers to reduce mortgage principal, which Richard Green, the director of the Lusk Center for Real Estate at USC, considers a shortcoming. "For underwater loans, if you don't write down the balance to be less than the value of the house, people still have an incentive to default," Green says. "Writing down the principal first instead of last—which is what [the Obama administration is] proposing—makes sense to me."
3. Cash incentives: To encourage participation, servicers will be paid $1,000 for each modification and will get an additional $1,000 payout each year for as many as three years, as long as the borrower continues making payments. Borrowers, meanwhile, can get up to $1,000 knocked off the principal of their loan each year for as many as five years if they make their payments on time. Neither party can receive the cash incentives until the modified loan payments have been made for at least three months.
4. Financial hardship: The Obama administration is pitching its plan as an effort to help responsible homeowners ensnared in the historic housing slump and painful recession—not speculators. As such, only owner-occupied, primary residences with outstanding principal balances of up to $729,750 are eligible. Occupancy status will be verified through documents, such as the borrower's credit report. In addition, the program is designed to target homeowners who are undergoing "serious hardships"—such as a loss of income—which have put them at risk of default. To participate, borrowers will have to sign an affidavit of financial hardship and verify their income with documents. "If we would have had such stringent verification over the last four or five years, we probably wouldn't be in as bad a position as we are in," says Richard Moody, the chief economist at Mission Residential. But while Moody has no objection to such verification, obtaining documents from so many homeowners could be an onerous effort. "It's going to be a very time-consuming process," he says. Only loans originated on or before Jan. 1, 2009, are eligible, and modified payments will remain in place for five years. Now that the administration's plan is out, lenders are free to begin modifying loans.
5. Net present value: To determine if a particular mortgage will be modified, the servicer will perform a so-called net present value test. The test compares the expected cash flow that the loan would generate if it is modified with the expected cash flow it would generate if it isn't. If the modified loan is expected to produce more cash flow for the mortgage holder, the servicer is to restructure the loan. Howard Glaser, a mortgage industry consultant and a U.S. Department of Housing and Urban Development official during the Clinton administration, called this component of the plan "clever," arguing that it would work to ensure broad participation. "When you apply the formula, the loans that are modified are the ones that are in the best economic interest of the investors to modify," Glaser says. "The federal subsidy for the payment on the modification…tips the scale toward modification as a better deal for the investor."
6. Second liens: The Obama plan also addresses the issue of second liens—such as home equity loans or home equity lines of credit—by offering incentives to extinguish them. But key details on this component of the plan remained unclear. "Distinguishing the second lien is really important," Green says. "[But] exactly how they are going to convince the second lien holder to do this is not clear to me at all."
7. Will it work? Moody argues that while the plan may reduce foreclosures for primary residences, it could lead to a spike in defaults for another group of homeowners. Although he supports the administration's efforts to focus the initiative on primary residences, Moody notes that "it could be the case that a lot of [real estate speculators] have been just hanging on waiting to see exactly what the details are of this [plan]," Moody says. Now that it's clear the Obama plan leaves speculators out, "we could actually see a spike in foreclosures or at least mortgage defaults among this group."
Glaser, meanwhile, worries that lenders may soon be overwhelmed by inquiries from homeowners looking to participate. "Starting today, millions of borrowers are going to start to call their lenders to see whether or not they are eligible," he said. "And I'm not sure that the financial services industry has the capacity to handle these inquiries."