A new government push to clean up bad home loans could dent bank earnings because the industry may have to take losses on the assets sooner than some investors expect.
The new effort, called Home Affordable Foreclosure Alternatives, or HAFA, kicks in April 5. Some banking and real-estate industry experts see it as a response to the limited success of a government loan modification drive known as the Home Affordable Modification Program, or HAMP.
"The administration wouldn't want to categorize it this way, but HAFA is an acknowledgement that a lot of loans won't meet the criteria for a HAMP modification — even a trial one," said Rick Sharga, senior vice president at RealtyTrac, which compiles data on foreclosures.
Slumping house prices and surging unemployment have triggered a wave of foreclosures that will continue washing over the U.S. banking industry for a few more years.
There could be foreclosure filings on 3 million to 3.5 million homes in 2010, according to RealtyTrac. There were a record 2.8 million homes with at least one foreclosure filing in 2009, the firm recently reported. Foreclosure activity will likely remain high until at least the end of 2012.
Foreclosures would probably have been higher last year if not for government and industry efforts to cushion the impact, including HAMP and state legislation extending the process.
Under HAMP, over 1 million homeowners have started trial modifications, which reduce monthly mortgage payments. However, less than 116,000 homeowners have a permanent modification under the program.
"HAMP hasn't worked," said Nancy Bush, president of bank industry research firm NAB Research. "It's just a massive expense of time and money."
Wells Fargo & Co. (WFC) has 15,000 people working on HAMP, she noted. In a recent meeting with Wells Fargo executives Bush said she asked when the program might end.
"They just shrugged their shoulders and said maybe never," Bush said. "The expense of that is huge. HAMP may turn out to be the most expensive thing the banking industry has ever done."
Under the new HAFA program, if a homeowner doesn't qualify for a HAMP modification they must be offered a short sale. Borrowers can also be offered a deed in lieu of foreclosure.
Homeowners who qualified for a HAMP modification, but have missed two consecutive payments, will also be offered a short sale or deed in lieu through HAFA.
A short sale happens when the borrower and the mortgage servicer agree to sell a home for less than the value of the loan or loans. A deed in lieu of foreclosure occurs when a homeowner voluntarily gives the deed of the property to the servicer.
To kick-start HAFA, there are government incentives. Borrowers get $1,500 to help them move to a new home, and up to $3,000 in short-sale proceeds can be given to holders of second mortgages on the homes in the program.
Short sales and deeds in lieu can be cheaper than foreclosure. Banks often spend $20,000 to $40,000 to put homes through a full foreclosure process, according to Rick Sharga, senior vice president at RealtyTrac.
With more than a million properties in some state of foreclosure and another five million homes with delinquent mortgages, the costs could be huge, Sharga said.
"Any savings through short sales will help," he added.
Short sales prevent properties sitting vacant for long periods. The transactions also sometimes happen before the properties ever get listed. This reduces the impact on other homes in the neighborhood, Sharga explained.
However, for short sales and deeds in lieu under HAFA, lenders will have to give up the right to go after borrowers if there's a deficiency on the mortgages.
Borrowers won't be on the hook if the home is sold for less than the value of the first mortgage. If the holder of the second mortgage gets an incentive payment from HAFA, the borrower is also not responsible for any shortfall on that loan too, according to the National Association of Realtors.
"That's the real fly in the ointment with HAFA," Sharga said. "I don't know how the banks will absorb these loan losses more quickly."
Banks holding second mortgages in these cases may be particularly vulnerable because such subordinate loans are sometimes wiped out when the homes are sold, he noted.
If HAFA takes off, banks may have to set aside more provisions earlier than some investors expect, cutting into earnings. This comes at a time when some investors expect the industry to start reducing the money it sets aside to cover loan losses soon.
The industry reported a fourth-quarter profit of just under $1 billion, a big improvement from the $37.8 billion loss it suffered during the final three months of 2008, according to Richard Bove, a bank analyst at Rochdale Securities.
"The recorded profit is due more to an accounting gimmick than an improvement in operating earnings," Bove wrote in a recent note to investors. "The industry decided to avoid building its reserves in the quarter to the same extent as nonperforming assets rose."
"If the reserves had been built to the level that was warranted by the increase in bad loans, the sector's profit would have been a multibillion loss," the analyst added.
Any program like HAFA would need to come with some sort of government help for banks, Bush said.
Loan losses stemming from HAFA may be treated differently in terms of provisioning or banks might be allowed to defer recognition of the losses, she explained.