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October 15th, 2009

Are Loan Mods Destroying the Mortgage Industry?

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In the days ahead, will the private Mortgage-Backed Securities (MBS) market cease to exist? Will loan modifications wind up destroying the long-standing playing field between lenders and second lien holders? Will the Fed ever be able to exit the mortgage market?

These questions have all come to mind because of unintended consequences brought on by the Making Home Affordable Modifications program. The program that was structured to assist failing homeowners has managed to create a host of uncertainties in its wake. A recent editorial in the Wall Street Journal wonders if the MBS market will be next.

Incentives for Second Liens

On Tuesday we wrote that the Treasury Department’s Office of Homeownership Preservation (OHP) announced that a new wrinkle to the Federal loan modification program is coming soon. The new loan mod effort will provide incentives to second lien investors to persuade them to participate in loan mods.

Lawmakers — and borrowers across the country — are up in arms to why more modifications aren’t being done at an even faster rate. Second lien investors have absorbed much of the blame, criticized for their slow participation in the process. Tuesday’s announcement by the OHP was designed to speed things along.

However, that “new wrinkle” — the involvement of second-lien investors — is perverting the nature of the contract that has existed between first and second lien investors for decades:

One reason the MBS market blossomed in the first place is because investors who bought a mortgage security believed that first mortgages were senior to second liens. In the event of a foreclosure, second liens would be extinguished first and holders of the first mortgage would get what was left because that’s what the contract said.

Outcomes: 1, 2, 3…4?

As fundamental as the relationship between first and second liens is the obligation of servicers to lenders. In the event of a failure, a servicer’s main objective is to maximize a lender’s return. In modern mortgage lending, lenders know and prepare for three possible outcomes that their loan might take:


1. It would be paid on time for the life of the loan

2. It would be refinanced or prepaid, and

3. If it became delinquent, it would be foreclosed.

With the inception of a national loan modification program, a widespread fourth outcome was created. Since this “fourth outcome” is new and relatively untested, it doesn’t provide lenders any absolutes to work with. What kinds of returns will they get, and over what periods of time? It doesn’t even prevent future losses very well, since about 50% of modified loans fail anyway. It doesn’t help lenders that the “fourth outcome” — the uncertain outcome — is the one that hundreds of thousands, if not millions, of American borrowers want or need.

Investors Want Absolutes

Any investor needs to know about any absolutes (outcomes 1-3) and understand the risks before they invest. They need to hedge against those risks to the greatest extent possible. With too many unknowns, it’s impossible to predict and manage risks and returns (which is one reason the market is in the mess it’s in now). Absent that clarity, investors may simply turn to simpler, more predictable investments –Treasuries and such.

Why has the Fed continued to buy mortgage investments? At present, simply because no one else in the private market wants to. By some calculations, the Fed has purchased 100% of the conforming MBS in the market this year.

Laurence Fink, Chairman of asset management firm BlackRock Inc., classifies the lack of participation in the private MBS market “one of the biggest issues facing American capitalism.”

From the Wall Street Journal:

A vibrant MBS market depends on the sanctity of U.S. contracts. If the world’s investors see that the Treasury is willing to reward banks at their expense, there will be fewer such investors in U.S. securities. There will also be less capital for housing. Treasury needs to revisit its foreclosure rules to protect the U.S. reputation of honoring contracts, and the faster the better.

As it stands now, the Fed’s plan to stop buying MBS on March 31, 2010. If they stick to that exit date, who will pick up the slack? If no one steps up, interest rates will have to increase to attract and reward investors who will accept these unknowns, and the number of borrowers who can qualify for loans will fall even further.

The Federal loan mod program is slated to expire in 2012. Potentially, investors could stay away until then…maybe even longer. If so, can we really expect the Federal Reserve to buy the market’s share of MBS for another two years, or longer? Is anyone in Washington drafting incentives to help get private-investor money back into the mortgage market?

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4 Responses to “Are Loan Mods Destroying the Mortgage Industry?”

  1. Are Loan Mods Destroying the Mortgage Industry? Says: October 15th, 2009 at 7:21 pm

    [...] News Sources wrote an interesting post today onHere’s a quick excerptIn the days ahead, will the private Mortgage-Backed Securities (MBS) market cease to exist? Will loan modifications wind up destroying the long-standing playing field between lenders and second lien holders? Will the Fed ever be able to exit the mortgage market? These questions have all come to mind because of unintended consequences brought on by the Making Home Affordable Modifications program. The program that was structured to assist failing homeowners has managed to create a host of unc [...]

  2. Lucia Says: October 15th, 2009 at 10:28 pm

    Good article. I learn something new every week.

  3. Tim Manni Says: October 18th, 2009 at 12:16 pm

    Thanks Lucia! This one took a little longer to write (and was a little longer than usual), so thanks for reading the whole thing.

    Thanks,
    Tim

  4. Reverse Mortgage Information Says: October 19th, 2009 at 2:46 am

    Hi

    This article is better for those people whose want to buy real estate.

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About the HSH Blog

HSH.com's daily blog focuses on the latest developments in the mortgage and housing markets. Our mission is to relate how changes in mortgage rates and housing policy, as well as the latest financial news, impacts consumers, homebuyers and industry insiders alike. Our 30-plus years of experience in the mortgage industry gives us an edge as we break down the latest changes in an ever-changing market.

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Tim Manni

Tim Manni is the Managing Editor of HSH.com and the author of their daily blog, which concentrates on the latest developments in the mortgage and housing markets.

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