Tweaking the Loss Mitigation Toolkit

While loss-mitigation tools today are far better than those available in the wake of the Great Financial Crisis, researchers at the Urban Institute have determined that there is room for improvement.

In a brief entitled "Loss Mitigation Toolkit Improvements for Borrowers Exiting COVID-19 Forbearance," the institute's VP of Housing Finance Policy Laurie Goodman and Senior Research Associates Karan Kaul and Michael Neal identify changes that they deduce could boost the toolkit's effectiveness.

Their first area of focus is the Federal Housing Administration's partial claim program, which defers the repayment of mortgage principal through an interest-free subordinate mortgage that is not due until the first mortgage is paid off.

The Institute research team proposes a more flexible partial claims program.

Their proposed change, they explain, "would front-load the benefit of a second lien/partial claim to provide a deeper temporary payment reduction than is possible today ... a portion of the partial claim amount would be used to reduce the monthly payment ... [which] would increase after a few years when the borrower has regained their financial footing."

The researchers say use of this option would maximize the number of FHA delinquencies that can be cured.

The second area of focus is homeowner equity. Most borrowers today have positive equity. The existing toolkit is tailored for negative equity situations, and that, they note, means some changes are needed.

This chiefly comes into play when foreclosure, home loss, or distressed sales become inevitable. The level of home equity impacts the process, an experience that will affect not only the homeowner, but also mortgagees, secondary lenders, the surrounding neighbors, and more. Thus, the facilitation of efficient move-out is exceedingly relevant, the researchers suggest.

"When borrowers have exhausted the home retention toolkit and cannot remain in the home, it is important to sell the home as quickly and as efficiently as possible, consistent with maximizing its value," they explain. "This prevents distressed properties from falling into disrepair and bringing down neighborhood home value. It also maximizes recoveries for the entity on the hook for credit losses, typically the GSEs, the FHA, or the VA."

They point out that during the last housing crisis widespread negative equity meant these entities had cause to maximize recoveries to cut losses.

"Because most struggling borrowers today owe less than the home is worth, the likelihood of losses is remote, which could decrease the incentive to facilitate speedy resolution," they report. "All else equal, a distressed property that sits in limbo will eventually sell at a deeper discount, which will come largely out of borrower’s equity even as the agencies make a full recovery."

With homes selling at record-high prices and inventory being scarce, the loss-mitigation toolkit should encourage struggling borrowers to sell their homes in the open market to maximize equity value, the researchers conclude.

They recommend the insurer or guarantor on the mortgage foot the bill for a housing counselor that can facilitate a smooth exit while maximizing recovery for the borrower and/or the provision of reasonable relocation allowances.

Fannie Mae, Freddie Mac, and the FHA offer up to $3,000 in relocation allowance to borrowers who complete a short sale or a deed in lieu of foreclosure, but the researchers suggest the amount should increase in line with increasing house prices and rents.

Another, longer-term solution suggested in the paper: a 40-year mortgage, something the government-sponsored enterprises Fannie Mae and Freddie Mac offer, they point out.

The FHA, however, faces two hurdles to this, they report.

"It does not have a portfolio to hold whole loans, and it relies on servicers to modify delinquent loans, which are then securitized again and sold to Ginnie Mae mortgage-backed securities (MBS) investors at the prevailing secondary price," they explain. "The secondary market for 40-year MBS is small and less liquid. Ginnie Mae recently announced a new pool type to support securitization of modified 40-year loans, but MBS pricing for loans with 40-year terms is less competitive relative to pricing for 30-year terms."

They touch on the risks and potential economical issues related to a 40-year loan, adding that developing this market will likely require a certain degree of government subsidy for investor, servicer, and borrower economics to work.

Although a 40-year secondary market is desirable, they say, "it is not something that can be expanded in time for the current crisis."

Ultimately, the authors reiterate that today's loss-mitigation toolkit beats what was available in 2008, and that forbearance programs and moratoria made a huge difference, but that the post-pandemic environment is different, thus the toolkit could use some relevant tweaks.