The task is daunting, but mortgage lenders and servicers are making some headway in the time-consuming work of modifying unaffordable loans for distressed borrowers who are near default.
New first-quarter figures from the Federal Housing Finance Agency showed 239,000 completed foreclosure preventions for Fannie Mae and Freddie Mac borrowers, up from 137,000 in the previous quarter. Government-sponsored-enterprise loan modifications jumped to 137,000 in the first three months, from 57,500 in the fourth quarter of 2009.
Impressive though these numbers are when looked at as percentage growth from quarter to quarter, they are minuscule when compared with the vast sea of underwater mortgages, those with principal balances higher than the current value of the home. Housing analysts estimate that 4.5 million homeowners are underwater by more than 33%.
Unless we address one of the fundamental problems of the housing crisis — negative equity — a significant majority of these borrowers could default, ballooning credit losses for already harried bankers and other mortgage lenders.
Federal and GSE home retention programs designed to keep underwater borrowers in their homes usually seek to reduce the interest rate of the loan, stretch out the payment terms and provide some forbearance of the principal balance. But what is missing in tackling negative equity is finding an alternative for outright principal forgiveness, which banks, lenders and investors understandably want to avoid.
Essentially a successful loan modification that includes writing down debt is similar to a typical corporate debt restructuring, a fair debt for equity exchange benefitting both the lender and borrower. In a debt-for-equity exchange, banks and lenders would see lower writedowns and avoid the plummeting net present value of home collateral caused by foreclosures and real estate owned inventories.
Realigning mortgage debt with the current value of a home will give underwater borrowers a fresh start and lower their monthly payments to a sustainable level, one they can afford. What makes this work for banks is a shared equity arrangement, which converts the bank's forgiveness of principal into a share of the future appreciation of the home from its current value.
A shared equity arrangement is not a reverse mortgage or a shared appreciation mortgage. It creates two liquid performing assets from an illiquid first mortgage, a newly modified or originated mortgage with a balance below the value of the home and a real estate agreement in the form of a purchase option.
This purchase option brings lenders and investors to the table, enabling them to recoup some of the debt forgiveness required to lessen the losses of the seriously delinquent and underwater mortgages in their portfolios. For banks a shared equity mortgage arrangement can help free up capital on the balance sheet by creating a new saleable performing mortgage and a liquid real estate agreement that can be sold or carried on the books at fair value.
The total value of a shared equity deal most likely will exceed that of other loan modification alternatives such as short sales and deeds in lieu.
And a shared equity arrangement can lead to lower loss provision requirements for banks if it lowers redefault rates associated with many loan modifications.
The real estate agreement in a shared equity deal — the purchase option — can be designed as a proprietary financial contract, which gives the lender or investor the right to share in a specified percentage of the future gain or loss in the home's value. Usually the gain or loss is realized when the home is sold.
Standardizing equity share contracts could help make real estate equity an asset class for institutional investors.
Shared equity arrangements first appeared during the real estate bull market as a debt-free way for homeowners to tap into their home equity and convert it into cash. But today they offer banks the opportunity to turn delinquent mortgages into new liquid performing loans and to be compensated for a portion of the principal that has been forgiven.
With strategic defaults on the rise as more underwater borrowers who can afford to pay walk away from their mortgage obligations, REO inventories necessarily will expand putting more downward pressure on home prices.
Equity share mortgages can help ameliorate some of that pressure and lessen potential loan portfolio losses.
