WASHINGTON — The Treasury Department and federal regulators released guidelines Wednesday on how banks should conduct loan modifications.
Part of a bid to prevent 7 million to 9 million borrowers from foreclosure, the guidelines are the first government effort to establish consistent nationwide modification standards.
Under the guidelines, lenders and servicers must follow a "waterfall" approach to lowering payments, work case by case to determine if a borrower is at imminent risk of default and conduct additional underwriting for many modified loans.
Industry observers said the plan was the government's best one to date to stop foreclosures.
"It's very ambitious," said Gil Schwartz, a partner at Schwartz & Ballen LLP. "It provides a healthy and generous incentive to homeowners and servicers and it could prove effective, depending on where the economy is going."
The centerpiece of the program is a one-time modification program for 4 million to 5 million homeowners for loans originated by Jan. 1, 2009. Under the plan, the government will provide incentives for servicers to reduce borrowers' monthly mortgage payments to no more than 38% of the borrower's income. After that point, the government will match further reductions by the lender to bring payments down to a 31% debt-to-income ratio.
Under the guidelines, servicers must follow a step-by-step "waterfall" approach to reduce a borrower's DTI to 31%. Lenders must first verify income, validate monthly payments, and capitalize accrued interest, past-due real estate taxes and insurance premiums and any other required fees that are due.
After that point, targeting a DTI of 31%, servicers must first attempt to reduce the interest rate to as low as 2%. If the target has not been reached, servicers must attempt to extend the term of the loan for up to 40 years. If the target is still not reached, servicers should forbear principal.
Servicers may also choose to reduce principal, but they are not required to do so.
Servicers can immediately begin using the guidance for modifications, but each loan can receive only one modification that would last from now until Dec. 31, 2012. After five years, the interest rate of the modified loan will increase gradually, by 1% a year.
That drew criticism from some consumer groups. "It's really disappointing, because it's not a longer-term solution," said Bruce Marks, the chief executive of the Neighborhood Assistance Corporation of America.
The Treasury said refinancing is sustainable because the servicer must verify and fully document the borrower's income and the net present value of the loan before the modification. "What this proposal does is provide a powerful set of incentives — incentives of persuasive force and some economic inducements — to provide substantial improvements in affordability to people who meet this important test," Treasury Secretary Timothy Geithner said at a Senate Finance hearing.
The government is trying to minimize redefaults by requiring a three-month trial period for each loan modification. If a borrower redefaults, he or she does not get a second chance to modify the loan. "The government learned from previous plans, so they're now requiring the borrower make three payments in a row before the loan mod becomes permanent," said Rich Rollins, the president and CEO of National Quick Sale, a Jacksonville, Fla., start-up that specializes in short sales, in which a home is sold for less than the mortgage balance and the lender accepts a discounted payoff.
The industry was also pleased the plan addresses second liens, which they said have impeded modifications so far. Under the plan, the government will provide $250 for each second lien a servicer extinguishes and may make a reimbursement payment of $1,000 to second-lien holders to extinguish the lien.
"It's too early to tell" the effect, "but it certainly helps, because second liens have been a huge part of the problem," said Karen Shaw Petrou, managing director of Federal Financial Analytics Inc.
The program provides various incentives for borrowers and servicers to participate. For example, the government will provide $1,000 for each modification, plus $1,000 per year for performing loans. Homeowners who make their payments on time may receive up to $1,000 for principal reduction for each year for five years.
The program distinguishes from past efforts by addressing not only delinquent loans, but also those performing but in imminent danger of default. To be considered in imminent danger of default, a borrower must be screened and prove hardship.
Jim Carr, chief operating officer of the National Community Reinvestment Coalition, said the plan tackles a key problem of other programs that force lenders to wait until a borrower falls behind on payments. "Most programs have encouraged you to be delinquent," he said.
The guidance said the hardship test "must ascertain whether the borrower has had a change in circumstances that causes financial hardship, or is facing a recent or imminent increase in the payment that is likely to create a financial hardship."
Each element must be verified through documentation. If the servicer determines that a performing borrower facing hardship will be unable to make their mortgage payments in the immediate future, the servicer must perform a net-present-value test.
The test is also required of any loan that is at least 60 days delinquent. Under the test, a servicer compares the net present value of cash flows expected from the modification to the net present value of cash flows in the absence of a modification. If the net present value of the modification scenario is greater, servicers must conduct the "waterfall" standard to reduce mortgage payments to 31% DTI.
The Treasury said the program is an all or nothing participation so that lenders do not use it just for "low-hanging fruit." All future recipients of government funds and the government-sponsored enterprises must use the guidance.
