[Senate Hearing 112-571]
[From the U.S. Government Publishing Office]
S. Hrg. 112-571
STRENGTHENING THE HOUSING MARKET AND MINIMIZING LOSSES TO TAXPAYERS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
HOUSING, TRANSPORTATION, AND COMMUNITY DEVELOPMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
SECOND SESSION
ON
EXAMINING ACTIONS THAT CAN STRENGTHEN THE MORTGAGE MARKET AT NO OR
MINIMAL COST TO TAXPAYERS
__________
MARCH 15, 2012
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.fdsys.gov /
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
Riker Vermilye, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Housing, Transportation, and Community Development
ROBERT MENENDEZ, New Jersey, Chairman
JIM DeMINT, South Carolina, Ranking Republican Member
JACK REED, Rhode Island MIKE CRAPO, Idaho
CHARLES E. SCHUMER, New York BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii PATRICK J. TOOMEY, Pennsylvania
SHERROD BROWN, Ohio MARK KIRK, Illinois
JON TESTER, Montana JERRY MORAN, Kansas
HERB KOHL, Wisconsin ROGER F. WICKER, Mississippi
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
Michael Passante, Subcommittee Staff Director
Jeff R. Murray, Republican Subcommittee Staff Director
Beth Cooper, Professional Staff Member
(ii)
C O N T E N T S
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THURSDAY, MARCH 15, 2012
Page
Opening statement of Chairman Menendez........................... 1
WITNESSES
John C. DiIorio, Chief Executive Officer, 1st Alliance Lending... 2
Prepared statement........................................... 21
Mark Calabria, Director of Financial Regulation Studies, CATO
Institute...................................................... 4
Prepared statement........................................... 22
Laurie S. Goodman, Senior Managing Director, Amherst Securities.. 6
Prepared statement........................................... 31
(iii)
STRENGTHENING THE HOUSING MARKET AND MINIMIZING LOSSES TO TAXPAYERS
----------
THURSDAY, MARCH 15, 2012
U.S. Senate,
Subcommittee on Housing, Transportation, and Community
Development,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee convened at 2:33 p.m., in room SD-538,
Dirksen Senate Office Building, Hon. Robert Menendez, Chairman
of the Subcommittee, presiding.
OPENING STATEMENT OF CHAIRMAN ROBERT MENENDEZ
Chairman Menendez. This hearing will come to order. Thank
you all for being here today.
The hearing of the Banking Subcommittee on Housing,
Transportation, and Community Development will examine actions
that can strengthen the mortgage market at no or minimal cost
to taxpayers, including mortgage modifications, such as
principal reduction or shared appreciation, reducing distressed
property sales, and increasing demand and people's ability to
buy homes. This hearing is an important one since the housing
market is often what anchors the broader economy and we need to
be able to fix the housing market to get the broader economy
moving more robustly again and to create jobs.
On a regular basis, I hear from New Jersey homeowners who
have trouble with their home loans, whether it is being denied
the opportunity to refinance at today's lower interest rates
because they are either underwater, or the lost paperwork and
years of waiting to get an answer on their request from a
mortgage modification from their bank, is a constant challenge.
Like the private sector, the Government should employ more
creative tools to reduce defaults and help the housing market
recover, such as principal reductions and shared appreciation
models, among other methods. In particular, I would note that
private banks are finding it more profitable than other methods
of mortgage modifications to do principal reductions on about
20 percent of their own portfolio loans, and yet the Government
is not even allowing principal reduction on any of its loans,
completely removing that tool from the toolbox. So I would like
to explore whether or not that makes sense from a simple
business judgment perspective about how to best protect
taxpayer assets and I look forward to examining these
innovative methods, among others, to get the housing market
back on track.
With no other Member at this point before the Subcommittee,
let me welcome all of our witnesses and I will introduce you.
John DiIorio is the Chief Executive Officer for 1st Alliance
Lending. Mr. DiIorio spent 15 years of experience in the
mortgage industry and has been at the forefront of loss
mitigation and refinance efforts. First Alliance is a leading
originator of both Hope for Homeowners and short refinance
loans, so we appreciate you coming.
Dr. Mark Calabria is the Director of Financial Regulation
of the CATO Institute, has worked there since 2009. Before
that, he was a senior member of the professional staff of this
Subcommittee and we appreciate him coming back. In that
position, he worked on issues related to housing, mortgage
finance, economics, banking, and insurance for Ranking Member
Shelby and he has appeared before the committee many times and
we appreciate him coming back to discuss today this issue.
Dr. Laurie Goodman is a Senior Managing Director at Amherst
Securities responsible for research and business development.
Before joining the firm in 2008, she was head of Fixed Income
and Research at UBS. She has also worked at CitiCorp, Goldman
Sachs, Merrill Lynch, and the Federal Reserve Bank of New York,
and she has appeared before us many times and offered great
experience.
So thank you all for coming. With that, Mr. DiIorio, we
will start with you and ask you to synthesize your oral
testimony to about 5 minutes. All of your statements will be
completely included in the record and this way we will have a
little time to have a discussion. Mr. DiIorio.
STATEMENT OF JOHN C. DiIORIO, CHIEF EXECUTIVE OFFICER, 1ST
ALLIANCE LENDING
Mr. DiIorio. Thank you, Senator. Chairman Menendez, Ranking
Member DeMint, and other Members of the Subcommittee, I
appreciate the opportunity to testify before you today. I am
the CEO of 1st Alliance Lending, a mortgage origination firm
that is a leader in originating FHA loans that offer both
affordability and principal reduction. We specialize in these
loans, which reduce principal for underwater borrowers and
provide affordable monthly mortgage payments.
There are a number of programs and loan options that have
been created in the last several years to help troubled
homeowners, including HAMP loan modifications, HARP, Fannie
Mae, and Freddie Mac refinancings, FHA streamlined
refinancings, and assistance to unemployed homeowners. While
these programs address affordability, generally, they do not
provide principal reduction.
We argue, and our experiences substantiate, that principal
reduction is critical in concert with affordability efforts in
providing long-term solutions to American homeowners. Moreover,
we are finding that sophisticated financial entities with their
own money at risk in these assets are using principal reduction
in a targeted manner to maximize the recovery value of these
mortgages. There is a growing consensus that supports these
conclusions and I appreciate the opportunity to share our
experiences on this subject.
According to CoreLogic, at the end of 2011, 11.1 million
homes are underwater. That simply means the amount of the
current mortgage exceeds the value of the property. It seems
hard to understand how we can address our underlying housing
problems and restore health to the housing market without
addressing this issue.
Homeowners who are underwater are house-locked, unable to
sell their home should they need to move for employment.
Homeowners who are significantly underwater, particularly in
areas where housing prices are less likely to recover, face the
prospect of a very long period in which they will have no
equity in their home. HAMP and other proprietary loan
modifications address affordability problems, but even HAMP
assistance phases out over time and ultimately borrowers
receiving payment modifications will continue to be faced with
the challenge of negative equity.
An often overlooked fact is that principal reduction, done
correctly and in a targeted manner, is sometimes the best
economic option for the holder of the mortgage and often
significantly enhances the value of the asset. In fact, we
increasingly see holders of underwater mortgages utilizing
principal reduction as part of their asset maximization
efforts. These are sophisticated counterparties acting in their
own financial best interest. Of course, where they utilize this
option, it is also good for the homeowner and, by extension,
for housing markets by reducing risk of default and
foreclosure.
First Alliance Lending works with a number of major banks,
investment banks, and sophisticated financial counterparties
who hold or purchase pools of single-family loans, including
loans to currently distressed and underwater borrowers. First
Alliance analyzes these pools to identify borrowers who qualify
for our programs and for whom it makes sense financially to
utilize this option.
We have utilized FHA refinance principal reduction
programs, which provide opportunities for these types of
distressed homeowners to refinance their existing loan, but
only the existing first mortgage holder forgives a portion of
principal in order to meet FHA's loan-to-value requirements.
For homeowners that qualify, we do far more than the
cursory calculations that are done for loan modifications. We
do full underwrites. We analyze the borrower's total debt
burden-to-income to make sure the homeowner is financially
sound and capable of meeting their financial obligations. These
steps are important in reducing redefault and foreclosure risk
because modifications which focus only on payment affordability
of the first mortgage loan do not take into account the
financial stress of other debt that the homeowner may have.
Again, let me emphasize, these investors and mortgage
holders that we work with agree to principal reductions
voluntarily. Moreover, they make the decision to do so in their
own financial best interest.
First Alliance has been underwriting FHA loss mitigation
loans long enough that we now have a track record with seasoned
loans. From the perspective of the FHA, I am very pleased to
let you know the redefault rates on these loans are very low,
far lower than ever expected. As of March 1, our default rate--
cumulative default rate--was just below 8.6 percent. This
performance, we contend, shows the powerful impact of principal
reduction.
There is significant question about moral hazard when it
comes to principal reduction. I hope we take some time to
address those questions today because I think it is an
important part of the discussion, and I want it to be known, we
do not experience a lot of moral hazard in our process. We are
not seeing borrowers who are looking for a free ride or a
handout. These are people that have genuine hardship. Refinance
with principal reduction offers them a long-term solution.
Thank you. I look forward to your questions.
Chairman Menendez. Thank you very much.
Dr. Calabria.
STATEMENT OF MARK CALABRIA, DIRECTOR OF FINANCIAL REGULATION
STUDIES, CATO INSTITUTE
Mr. Calabria. Chairman Menendez, Senator Corker, other
Members of the Committee, thank you for the invitation to
appear at today's hearing.
Before delving into maybe the less cheery aspects of my
testimony, let me first say that I believe that there is a very
strong likelihood that 2012 is going to be the year that the
national housing market hits bottom. I expect there to be
continued depreciation, but I expect it to be small, on the
order of around 3 percent. I also say I think a number of
metropolitan markets might actually see positive appreciation
later in this year. So the positive is, I do think we are
getting very close to a bottom.
A turn around in the housing market, even if it is modest,
would have a substantial impact on both the mortgage market and
the overall economy. As importantly, the recent improvements in
the labor market will ultimately filter through to the housing
market. In fact, I would say I do not think there is any bigger
driver behind the housing market today than the labor market.
Stabilization or modest improvement in house prices will also
change the incentive for borrowers to default. It is not simply
the level of prices, but also the direction of prices that
impacts a borrower's decision to default. Further appreciation,
even from a position of negative equity, will reduce the rate
of defaults.
As we know, our housing and mortgage markets are in
distress. Rather than repeat that here, let me focus on what I
think are a few bright spots as well as a few dark spots.
First, despite all the talk about negative equity and
strategic default, the vast majority of underwater borrowers
continue to pay their mortgages. For prime borrowers, over 75
percent of underwater borrowers are current. Even the majority
of subprime borrowers are current. The fact is that most
Americans believe they have an obligation to honor their
commitments. According to a recent Fannie Mae National Housing
Survey, only about 10 percent of respondents thought it was
appropriate to walk away from a mortgage they could not
otherwise pay. On the other hand, about a fifth of subprime
borrowers with significant positive equity are currently 90
days late or more--60 days late or more. We have to keep in
mind that foreclosure is driven by far more than just equity.
On the gloomier side, about 40 percent of loans currently
in foreclosure have not made a payment in over 2 years. Over 70
percent of loans have not made a payment in over a year. Quite
frankly, it is hard for me to imagine many of these borrowers
ever becoming current again.
Almost half of loans currently entering foreclosure today
were previously in foreclosure at some point in the past. The
good news is that new problem loans, that is, loans that were
current 6 months previous to becoming late, actually peaked in
the spring of 2009 and have been steadily declining ever since.
Before turning to where I disagree with my fellow
panelists, let me first emphasize there is a considerable
amount of agreement. For instance, I believed increased bulk
sales by the GSEs can serve as a useful way to get properties
back into the marketplace. I believe there is a substantial
amount of investor money willing and able to purchase GSE REOs
in bulk. These purchases could then be converted into rental or
rehab and sold for home ownership. Of course, this must be done
in a way to maximize the return for the taxpayer.
Let me emphasize another point of agreement, which is that
improving credit availability is perhaps, you know, in my
opinion, the most important piece. What is holding back our
housing market is a combination of weak demand and excess
supply. Part of that weak demand is a result of excessively
tight credit standards. My estimate is that between 2006 and
today, about a fifth of the mortgage market has disappeared.
Obviously, some of that credit we do not want to come back, but
some of it, we do. Of course, drawing the appropriate line is
always harder in practice than in theory.
One line that I believe that has been drawn too tightly are
the Federal Reserve's 2008 changes to HOEPA. Under these
changes, and at today's interest rate, any mortgage over 5.5
percent would be considered high cost. We all know that,
historically speaking, 5.5 percent is not a bad rate. Some
would say it is actually a great rate and is certainly not per
se predatory. We also know the HOEPA label carries with it
substantial regulatory, reputational, and litigation risk.
While it is hard to measure the exact impact of this
regulation, the evidence indicates to me that the 2008 HOEPA
changes have eliminated a significant part of our mortgage
market.
Laurie in her testimony also touches upon the qualified
mortgage definition. I think that is something that needs to be
rethought, as well. It would have a detrimental impact on
mortgage availability.
Now moving to the point of disagreement, namely the topic
of principal reduction, first, let me say I applaud those
lenders and investors who have found a way to make it work. I
think other lenders should take a look at that. I think other
investors should try to take a look at it.
But I think that it is important to remember that the
Government plays by a different set of rules and incentives.
Lenders have been able to do principal reduction on a case-by-
case basis. I think in a world of both politics and, just as
importantly, due process, we should not pretend that the GSEs
should be able to operate in the same manner.
My fellow panelist modified his suggestion for principal
reduction by saying, quote, ``done correctly and in a targeted
manner.'' Quite frankly, these are not terms that I would
generally use to describe our Federal foreclosure efforts. My
fellow panelist has also stated that his firm uses principal
reduction for borrowers who have experienced an adverse life
event and not simply for those who do not want to pay. I think
this is an incredibly important qualification.
Ms. Goodman also suggests in her testimony to limit
principal reduction to those who are already delinquent. I
would agree with that here. But if you are going to do
principal reduction, which I have a great deal of skepticism
about, I do believe you need to limit it to borrowers who are
both already late and have exhibited some inability to pay. For
those who simply do not want to pay, quite frankly, I think we
should treat them as anyone else who does not want to honor
their obligations. Let us be clear that anybody who defaults on
a GSE or FHA loan is costing the taxpayer and should be treated
as such.
Now, I believe the reason that the GSEs should not be
forced to preserve principal reduction is that loan
forbearance, in my opinion, is already an effective and
generous method for dealing with the inability to pay. If a
borrower cannot pay now, then we should not require them to do
so. In the future, when we hope that they can pay, we can
require such. I will note that this also allows for the
preservation of GSE assets that is consistent with the
statutory language of HERO.
Again, I thank you for your attention. I look forward to
your comments and questions.
Chairman Menendez. Thank you.
Dr. Goodman.
STATEMENT OF LAURIE S. GOODMAN, SENIOR MANAGING DIRECTOR,
AMHERST SECURITIES
Ms. Goodman. Chairman Menendez and Members of the
Subcommittee, thank you for the invitation to testify today. My
name is Laurie Goodman and I am a Senior Managing Director at
Amherst Securities Group, a leading broker-dealer specializing
in the trading of residential and commercial mortgage-backed
securities. I am in charge of our strategy effort, which
performs extensive data-intensive studies in an effort to keep
ourselves and our customers informed of critical trends in the
market.
As you know, the housing market remains in very fragile
condition. To strengthen the market, we need to decrease the
number of distressed homes for sale. This is best done by
increasing the success rate on modification through greater
reliance on principal reduction. We also need to increase the
demand for distressed homes, both through a ramp-up of the bulk
sales program coupled with financing for these properties and a
careful vetting of new rules that affect already tight credit
availability.
Investors recognize that foreclosure is the worst outcome
for both the borrower and the investor. If a home is foreclosed
on, it will sell at a foreclosure discount and the recovery to
the investor will be further reduced by the heavy costs and
expenses that are associated with long foreclosure timelines.
It is far more economic for the investor if the borrower is
given a sustainable modification.
The types of modifications have changed dramatically over
time. There are fewer capitalization modifications in which
neither interest rate nor principal balance are decreased.
There are many more rate modifications, and more recently,
increased use of principal reduction. As you point out, banks
have long used principal reduction on their own portfolio. They
are now using it extensively for loans and private label
securities as it has been shown to be the most effective type
of modification. This makes sense, because you are re-equifying
the borrower.
The one place principal reduction is not being used is on
Fannie and Freddie loans. Fannie and Freddie have no regulatory
obstacles to using principal reduction but have chosen not to.
Ed DeMarco submitted a letter to Congress detailing the results
of an FHFA study showing that principal reduction does not
result in a higher value to the GSEs than forbearance. We have
reviewed the study and have a number of very substantial
objections.
First, there are quite a number of serious technical flaws
in the conduct of the study, which is outlined in my written
testimony, all of which have the effect of making forgiveness a
less attractive option. One example: The results assume that
either all borrowers will modify using forgiveness or all
modified using forbearance. Looking at the benefit to the GSEs
of using multiple strategies was not considered.
Second, the Treasury NPV model, a theoretical model, was
used for the analysis. The principal reduction alternative
under HAMP has been available for almost 18 months. We have
real results and they should have been used.
Finally, the FHFA did not break out loans with and without
mortgage insurance. Principal forgiveness is most likely not
going to be NPV-positive for loans with mortgage insurance
because the GSEs bear the entire cost of the write-down. The
insurer does not cover the written down amount if the borrower
defaults. We believe that if the analysis was done correctly,
the FHFA would have found principal forgiveness makes sense for
loans without mortgage insurance, which is two-thirds of their
book of business.
FHFA and the GSEs are very concerned about the moral hazard
issue. Will borrowers who are current default in order to get a
principal write-down? This is a particular worry as more than
90 percent of their book of business is current. We think the
moral hazard issue can be easily contained. A provision can be
included that the borrower has to be delinquent by a certain
date to take advantage of it. Alternatively, a feature can be
included such that if the borrower takes the principal
reduction, he shares future appreciation with the lender.
Senator Menendez, I know you have been supportive of this idea.
New measures permitting the GSEs to be eligible for
principal reduction incentive payments and the recent tripling
of these incentives should make it more attractive for the GSEs
to do forgiveness. In light of these changes, I would urge the
FHFA to redo their results, correcting the technical flaws in
their study and separating loans with and without mortgage
insurance.
Now, I would like to turn to measures that will increase
the demand for housing, bulk sales, and credit availability. We
are very pleased to see Fannie Mae initiate their bulk sales
program. We believe the execution will be very favorable to
taxpayers because large-scale investors will pay a bulk sales
premium in order to buy a block of homes in a given geographic
area. A bulk purchase makes it easier to justify the costs of
initiating a professional property management organization in
that area. Providing financing will allow for even more
favorable execution, encouraging increased use of these
programs. I testified before this Subcommittee last September
on this issue.
Finally, we are very concerned about credit availability.
Lending standards were certainly too loose in the 2005 to 2007
period, as Dr. Calabria pointed out, but are now too tight, and
we are concerned that every single action that is being
contemplated will actually make it tighter. Our particular
concern is the qualified mortgage, or QM, standards. Dodd-Frank
required the CFPB to define a qualified mortgage, which is an
ability-to-pay measure. The CFPB is unlikely to provide
servicers with a safe harbor. Most likely, this will be done as
a rebuttable presumption. If this is the case, a bright line
test is critical, as lenders are concerned that default itself
is evidence of a lack of ability to repay. There is unlikely to
be a vibrant market for non-QM loans because of the liability
associated with originating these loans. Careful crafting of
the QM rule is critical. A greater uncertainty for lenders
means that already tight credit availability will get tighter.
In my testimony today, I have discussed three actions that
can strengthen the mortgage market at no or minimal cost to
taxpayers: Increasing reliance on principal reduction
modifications, a ramp-up of the bulk sales program coupled with
financing for these properties, and a careful vetting of new
rules that affect already tight credit availability. We urge
Congress to do everything they can to facilitate these actions.
Thank you very much.
Chairman Menendez. Thank you all for your testimony. I
appreciate it.
Let me start off the line of questioning. I have a lot of
questions, but let me start off with one line with you, Ms.
Goodman, and it is to follow some of your testimony. You know,
you cited a number of reasons why FHFA's analysis of principal
reduction is either flawed or incomplete and I wanted to go
through those with you.
First, I would note that FHFA's own analysis show that
principal reduction and principal forbearance are extremely
close in their value to taxpayers, so even forgetting about the
benefits to homeowners of the overall stability of the housing
market, just on that basis alone, there is an argument to be
made from their own analysis. Did the FHFA analysis of
principal reduction versus principal forbearance include the
effect of the Administration's tripling of incentives for
principal reduction?
Ms. Goodman. It did not.
Chairman Menendez. Could you put your microphone on.
Ms. Goodman. It did not include it.
Chairman Menendez. Do you think that if they had included
those incentives, the analysis would change the outcome?
Ms. Goodman. Absolutely. As you point out, it was very
close to begin with. Their study was done before the triple
incentives were announced and before Fannie and Freddie were
eligible for any of these payments. Including these results
would most certainly have changed the analysis, which, as you
point out, was very close to begin with.
Chairman Menendez. You also stated in your testimony that
FHFA should use principal reduction data in its analysis, not
just the NPV analysis which has problems. Why is it important
to use actual data on principal reduction or shared
appreciation?
Ms. Goodman. If you were looking to extend a medical drug
and had some trial results, you would be using those results in
your case to seek approval to extend the drug. If you have got
real results, you should use those real results rather than
some theoretical model which was done before those results were
available. And remember, we have almost 18 months of real HAMP
data on the principal reduction alternative that should be
mined.
Chairman Menendez. Let me ask you, you went on to say that
the FHFA should have analyzed loans with mortgage insurance and
without mortgage insurance----
Ms. Goodman. Yes.
Chairman Menendez. ----separately, and that the analysis
would have likely shown that principal reduction makes sense
for many loans without mortgage insurance.
Ms. Goodman. Correct.
Chairman Menendez. Can you explain why breaking down the
analysis this way matters in terms of targeting loans for which
principal reduction would be both beneficial to the taxpayer as
well as the homeowner?
Ms. Goodman. That is correct. You know, the problem with
doing principal reduction on loans with mortgage insurance is
that Fannie and Freddie are essentially subsidizing the
mortgage insurer. That is, the mortgage insurer does generally
not cover the amount of forgiven principal. So if you have got
a Fannie or Freddie loan that a mortgage insurer will cover
down to, say, 70 percent--and Fannie does principal reduction
on that loan down to, say, 80 percent, the mortgage insurer's
liability is limited to 10 percent rather than to 30 percent as
it originally was.
Chairman Menendez. Now, let me ask you one other thing.
What does not make sense to me, and maybe you can explain it to
me, is that the FHFA seems to be saying that there are no GSE
borrowers in the entire country for whom principal reduction
makes sense. I mean, this is not a question of just using it
across the board. But they say it does not make sense anywhere.
And yet the private sector seems to be saying it makes sense--
and they make decisions based on the bottom line--for about 20
percent of their loans. How does one reconcile that?
Ms. Goodman. I think the FHFA study was seriously flawed in
that it did not allow some borrowers to get forbearance and
some borrowers to get forgiveness. It required either all
forbearance or all forgiveness. And in reality in the private
sector, we optimize each loan. That is how it should be done
and that is how the GSEs should be doing it, as well. If they
had done this analysis in that manner, they would have found
that for some loans, principal forgiveness was beneficial both
to the taxpayer and to the borrower.
I think, to some extent, their fears of moral hazard sort
of clouded the analysis, because every single decision that was
made in the analysis skews the analysis against finding
principal forgiveness to be a profitable strategy.
Chairman Menendez. And on that question, Mr. DiIorio, you
said you wanted to talk about moral hazard, the challenge it
has presented that you did not find in your experiences. Can
you talk about that for a moment.
Mr. DiIorio. Sure. I think one of the problems with moral
hazard is it is often misunderstood. Moral hazard is really the
assumption that one party in a contractual agreement is going
to act irresponsibly because there is lack of consequence.
We do not see that, and these borrowers are referred to us
directly by sophisticated counterparties who are making the
decision that this is their best economic option. And the
borrower really does not have much choice as to whether or not
that transaction proceeds. It is really more in the hands of
the current holder of the asset.
So the idea that that is somehow going to lead to mass
default just does not seem to be supported by reality. It is
just not what we see every day.
Chairman Menendez. Thank you.
Senator Corker.
Senator Corker. Thank you, Mr. Chairman, and I thank all of
you for being here.
Mr. DiIorio, I appreciated your comments about this being
tailored appropriately and you all knowing your customers. And
I guess one of the concerns that people have had with the HAMP
program is that when Government is doing this in a very broad-
based way and does not know its customers, it is very difficult
for principal reduction programs that, you know, you have a
``check the box,'' you do this box, you do this box. It is a
very different arrangement than the way you deal with your
customers. And I wonder if you might have any additional
comments regarding the differences between an entity like you
that knows your customers and deals with them in a tighter way
versus these massive programs that we put in place that cannot
work in that manner.
Mr. DiIorio. Sure. I think that Dr. Goodman's testimony was
spot on when she talked about the FHFA analysis, right. They
were assuming either one blanket solution for their entire
portfolio or another blanket solution for the entire portfolio.
Senator Corker. But is that not the way HAMP is?
Mr. DiIorio. Uh----
Senator Corker. I know we are not talking about HAMP for
the GSEs----
Mr. DiIorio. Yes----
Senator Corker. ----but that is the way our HAMP program
is, is it not?
Mr. DiIorio. Yes, to a certain extent. But I think our
experience with private investors, right, and all of this is
driven by the private market, which we think is imperative, is
that they are making these decisions in sort of a waterfall
fashion. So they will say, I have got loss mitigation
refinance, I have short sale, I have got foreclosure, and they
have got these different options where they can measure their
economic recovery based upon a specific situation. We think
that is exactly how it needs to be done, that it needs to be
done on a loan-by-loan analysis.
Senator Corker. But the way we set up programs is more of a
one-size-fits-all process and it is more difficult to do when
you are just laying out, this is the way the Government is
going to do it. Is that yes or no?
Mr. DiIorio. I do not believe there is a one-size-fits-all
solution to this problem.
Senator Corker. OK. Yes, sir, Dr. Calabria.
Mr. Calabria. If I could just make a quick comment, we do
have to keep in mind that with any Government program, there
are basic due process concerns. I mean, to say that one person
would be eligible and one person would not, all those things
are going to be repealed. I mean, we do not sit around with
unemployment insurance and ask who is going to try harder to
find a job or not. You are eligible, you get it.
Senator Corker. That is right. Following up on that, the
principal reductions that we have been talking about, talk a
little bit about how--let me give an editorial comment. It is
my opinion the second lien holders are benefiting and the
primary lien holder is basically having a transference of
wealth here, and that is one of the big problems with these
principal reductions, is it not? Both of you.
Mr. Calabria. I think that is absolutely the case. Parties
bargain for different places in the line, chains of priority.
The second liens get a higher return. They take a higher risk.
You know, quite frankly, before any first lien takes a hit, it
is my opinion that the second lien should be completely wiped
out, not a proportional change but completely wiped out before
the first lien takes a hit at all.
Senator Corker. And that is not the way the massive
settlement that we did in the AG's Office worked, was it? I
mean, the second lien holders are ending up having the same
rights as the first lien holders.
Mr. Calabria. Very much a transfer from the first lien
holders to the second lien holders, which, I will note, more
often than not, the first lien holders are the investors,
whether it is pension funds and such, and the second lien
holders are the banks.
Senator Corker. Yes. Dr. Goodman, do you want to comment?
Ms. Goodman. I agree with everything Dr. Calabria just
said, and the one thing I would like to emphasize is there is
no one who has been more of an advocate of principal reduction
over the last almost 3 years than I have. Nonetheless, the
Attorney General's settlement scares me a great deal because,
essentially, banks are getting credit for writing down investor
loans, and it was pointed out----
Senator Corker. And, by the way, those investor loans, I am
so glad that especially you are saying that at this hearing.
But those investor loans, those are 401(k) programs and pension
programs, and so what we did was cram down----
Ms. Goodman. Yes, and there is no----
Senator Corker. ----people's 401(k)s and investments and we
benefited second lien holders----
Ms. Goodman. Yes.
Senator Corker. ----did we not?
Ms. Goodman. Yes. The second lien and first lien take a
write-down proportionately and the second lien holder should
have been written off completely before the first lien holder
takes a hit. And what is even more frightening here is that the
banks have broad authority to figure out how exactly they want
to fulfill the credits under this, be it to write down their
own loans or to write down investor loans. And the potential
for abuse is there.
Senator Corker. I know the time is up, but let me just ask
one last question. The rebuttable presumption issue that you
have brought up that is in Dodd-Frank basically says, I mean,
if a lender makes a loan and it ever goes bad, then, in
essence, as if they should have known better in the first
place, which is going to be incredibly dampening on credit, and
not having a safe harbor is going to be a killer going down the
road as it relates to credit, is that not correct?
Ms. Goodman. Absolutely correct.
Senator Corker. Thank you so much for this hearing.
Chairman Menendez. Thank you, Senator Corker.
Senator Merkley.
Senator Merkley. Thank you, Mr. Chair, and thank you to all
of you for your testimony.
I wanted to start, Dr. Goodman, with your testimony about
the NPV model that FHFA used. I was really struck because
Members of this panel have asked for the details of how that
model was constructed to be shared with the U.S. Senate and we
have gotten basically nothing, nothing in detail. And I look at
what--you are able to note the attributes of the loan at
origination were used in those models rather than current
attributes, for example, in FICO scores. Were you able to get
access to all of the data they generated, and how did you do
that? We need some education on this, on how to get
information.
Ms. Goodman. I made about 50 phone calls.
Senator Merkley. Well, good job.
Ms. Goodman. You are correct. The information was not
available in one place. We looked through the documentation we
had on the NPV model and were unable to construct exactly what
was done in the study and made a bunch of phone calls to figure
it out.
Senator Merkley. And so it was not because the FHFA
cooperated with you and said, yes, we should make this fully
transparent. It should be analyzed. It was not because you got
that sort of cooperation.
Ms. Goodman. That is correct. We are very persistent.
Senator Merkley. Well, well done, and I am going to renew
my call to Mr. DeMarco to share his study. It is important for
analysts to be able to look at the details, because as a former
analyst myself, I can tell you the assumptions that are hidden
deep inside a model, you can bend the outcome pretty much where
you want to take it, and I think that was your conclusion here.
Ms. Goodman. Absolutely. Thank you.
Senator Merkley. I want to turn to the bulk sale premium
program, and I note your enthusiasm for it. And you mentioned a
bulk sale premium. I assume that is that someone would pay more
in order to have all the properties in a particular location to
facilitate a management company being able to service those
properties.
Ms. Goodman. That is correct.
Senator Merkley. What level of premium would come from that
sort of thing?
Ms. Goodman. We will see when the first pilot program is
actually executed. You have got a lot of private capital being
raised for exactly this purpose, and accumulating 3 homes in
Indianapolis, 12 in Atlanta, and 15 in Dallas does a large-
scale investor absolutely no good because they cannot put into
place a professional property management organization.
Being able to accumulate 200 homes in a given area is
really, really important to being able to put into place that
organization. So if you want to get into an area, you are
willing to most likely pay a premium in order to do that, and
more of a premium if financing is provided. We will see exactly
what the premium looks like as a result of the trial program.
Senator Merkley. OK. So I am going to share with you why I
was not quite as excited as you were, and maybe you can tell me
where my perspective is off here. But everything that I had
seen before said that there would be a 30 to 40 percent
discount for people who bought the homes in bulk, just because
of the large transaction, and I have seen those sorts of deals
done in the past, so that sounded reasonable to me.
And I thought, you know, here are all these families out
there who have a chance to buy a home at historically low
prices, low interest rates. Why do we not offer that 30 to 40
percent discount for working families to buy these homes first,
you know, create a 2-month window, and then if they are not
sold, then offer them to the bulk investors. And I just feel
like ordinary families, they do not even benefit from the home
mortgage interest deduction, and the simple math of a $200,000
home with 10 percent down, so you are talking $180,000 at 5
percent, that is $9,000 in interest and the standard deduction
is $11,000. So ordinary families do not even benefit from the
home mortgage interest deduction. Here is a historic
opportunity. Why should we not give families that 30 to 40
percent discount opportunity, and then if they do not take it,
offer it to investors?
Ms. Goodman. I think there are a couple of things.
Basically, there is a benefit to the entire housing market of
having the overhang sort of sopped up in bulk. To the extent
that you offer it on one-off deals first, you end up with
extremely adversely selected homes available for sale in bulk.
In addition, another benefit of bulk sales is quick
execution. Remember, every day that a home is sitting there,
whoever the lender is is paying the taxes and insurance on that
home. Every day the home is sitting vacant or with a borrower
who is not paying their mortgage, the home is deteriorating and
losing value. So to the extent you do bulk sales and you are
able to do a lot of properties very quickly, it is a benefit to
the entire housing market.
I do not think you are going to see a 30 to 40 percent
discount on those properties. I would be absolutely shocked.
And furthermore, Fannie and Freddie would not sell them at a 30
or 40 percent discount. There would just be no trade. And there
are advantages to a quick sale in terms of the ultimate savings
to the taxpayer.
Senator Merkley. I take your point. I take your point if
there is not a substantial discount for the bulk sales, then we
are not talking about bypassing that for working families. I
have seen it argued otherwise, but maybe in this pilot project
that will not exist. I will be interested in following that.
And your point on quick execution, absolutely. But if there
is a discount of 30 to 40 percent, you would get quick
execution for those homes to families, as well. Some of the
folks in the audience here are reminding us about the 99
percent in America. Sometimes we structure deals that continue
to benefit really big investors and we miss opportunities to
help out working families and I just want to make sure we do
not do that in this case.
Ms. Goodman. Let me just remind you that between Fannie,
Freddie, and FHA, they have about 211,000 properties in REO
alone, let alone what is in foreclosure. I think there is
enough to go around for everyone.
Senator Merkley. Thank you. Thank you, Mr. Chair.
Chairman Menendez. Thank you.
I have one or two quick questions. First of all, I want to
follow up on Senator Corker's line of questioning.
Notwithstanding what the AGs did and the consequences to first
and second lien holders, but particularly first lien holders,
is there anything in the line of questioning that you and I
went back and forth over that would be altered by the answer
you gave him?
Ms. Goodman. No. Principal reduction is still the best form
of modification. It still makes more sense to the first lien
investor than any other alternative.
Chairman Menendez. Dr. Calabria, let me ask you, on another
question, you mentioned that one of the major constraints on
the market is mortgage availability, and I agree that credit
issues is a problem. Certainly, the odds of a person getting a
mortgage if you are not in the prime borrowers with substantial
downpayment is pretty dismal at this time, at least without
FHA. What needs to happen to increase credit availability for
good potential borrowers, and is QRM part of this issue,
because I am concerned that a QRM that some are suggesting is
20, 25 percent down as the standard, at the end of the day,
eliminates--without looking at a series of other factors--
eliminates a large swath of responsible borrowers at the end of
the day. Give me your insights.
Mr. Calabria. Let me say, I absolutely agree that part of
the problem is credit availability. Part of the problem is
obviously we do not fully want to go back to, say, 2005, 2006.
Some of that credit, we do not want to come back. But
absolutely, today, if you are a prime borrower who can put a
lot down, you can get a great rate. If you do not fit into that
box, you do not get a loan.
And so I absolutely have very strong concerns about the
risk retention and QRM rules. I have strong concerns about the
QM. And I have strong concerns about existing HOEPA and TILA
regulations in terms of that affecting it. So I do think it is
very difficult for anybody who is Alt-A or even the higher
quality of previous subprime to get a loan today in the absence
of FHA. And so because I do think we need to have a long-term
path to have the taxpayer less backing behind FHA and Freddie
and Fannie, we need to find ways to get private investors back
into this.
I do not want to beat a dead horse with the AG settlement,
but the things that do transfer the losses from the lenders to
the investors, in my opinion, pushes private capital out of
that market. And so I do think we need to be concerned about
bringing private capital back in the market and not subjecting
it to political risk. So to the extent that we can rethink any
of that and make sure that we are drawing the line appropriate
so that we do not have predatory lending come back but we do
have higher-cost responsible lending come back that reflects
the credit risk of the borrower, we absolutely need to do that.
Chairman Menendez. Let me ask you one other question. You
said that a third of all FHA borrowers are now underwater and
that FHA should exercise their power under Section 203(b)'s
program to aid borrowers. Explain to me how that would work.
Mr. Calabria. OK. Well, first, let us start with that most
of these FHA borrowers, about a third of which are underwater,
these loans were made since the burst in the bubble, and this
is why I think we need to draw the line correctly, because it
is important to get credit availability, but it is also
important not to simply create additional foreclosures.
And so under 203(b), one of the things I have suggested is
that these loans, by statute, have recourse. And so if a
borrower can pay, should be expected to pay, and the FHA can
exercise that. They do not. And I would emphasize that is very
different than the situation for somebody who cannot pay. And
so I think you need to be able to separate that.
And a lot of the talk about principal reduction is about
changing borrower incentives. I think I would characterize a
lot of what Laurie has talked about is providing carrots. I
would say that the Federal Government has some ability to
provide some sticks for those who simply choose not to honor
their obligations. For those who cannot honor their
obligations, we can have a different set of rules.
Chairman Menendez. For those who cannot honor their
obligations, do you consider the possibility--of course, this
is a case-by-case basis--of principal reduction as a
possibility in the portfolio, in the tool of things to be used?
Mr. Calabria. Well, my preference would be that we have to
keep in mind that it is always the interaction of negative
equity with something else--job loss, unexpected expense of
some sort. So my first--one way of sort of parsing out those
who can pay but do not want to versus those who cannot pay is
to look at the underlying cause. So if there is something we
could have programs targeted directly toward--if you have lost
your job--that, to me, is the No. 1 driver.
But I would say in a very roundabout way to get back to
answering your question, yes, that is a legitimate tool for
those subset of families that I think want to pay, want to stay
in the house, but are having difficulty, and the solution to me
is address that difficulty directly and to remember that it is
not the negative equity in and of itself causing the
difficulty.
Chairman Menendez. All right.
Mr. DiIorio. Senator Menendez----
Chairman Menendez. Yes, Mr. DiIorio, go ahead.
Mr. DiIorio. I would--unfortunately, Senator Corker has
left. On the second lien issue, I can promise you, every single
transaction that goes through our firm, all subordinate liens
are extinguished, not just second mortgages. And what we see
happen is usually the first mortgage holder and the subordinate
lien holders engage each other and they negotiate some sort of
agreement that leaves the borrower with a single lien.
So I understand the concerns that are being communicated
today about the AG settlement and I think that they are
somewhat valid, but that is not what is happening. Second liens
are getting out of the way, usually for pennies on the dollar.
Chairman Menendez. You preempted my question. Thank you for
that comment.
Senator Reed.
Senator Reed. Well, thank you very much, Mr. Chairman, and
thank you for your testimony. I was on the floor, so forgive my
late arrival.
Mr. DiIorio, you noted your clients consist of major banks,
investment banks, very sophisticated financial institutions.
And you further state that, as I understand it, they are in
favor of principal reduction, quote, ``not out of a sense of
charity but because they believe it is in their best financial
interest to do so.'' And so I just want to be clear that I
presume from your perspective there is a very strong business
case for principal reduction. It is not a matter of being kind
to people. It is the bottom line.
Mr. DiIorio. Absolutely. Our counterparties, they are
making financial decisions. There is a lot of talk about NPV,
and it is interesting because they all have different NPV
models and they are all proprietary and they are all figuring
it out in different ways.
But at the end of the day, what we see, what we see
happening in the private marketplace is not only are they
making the decision, quite frankly, for a segment of their
portfolio, it is their first choice, and it is their first
choice for one specific reason. It is the most economically
viable solution.
So that is--back to Dr. Goodman's testimony about the FHFA
analysis, you cannot blanket this. It cannot be done. It needs
to be analyzed. There are certain segments of the portfolio. It
is data driven. And there is no doubt that for a certain
segment of every portfolio, principal reduction is the best
answer.
Senator Reed. And that would include, obviously, Fannie and
Freddie.
Mr. DiIorio. I believe it does.
Senator Reed. Thank you. You know, just to follow on, what
is usually thrown up is just not an analytical but an
emotional, oh, it is moral hazard, and you go on very
specifically about the issue of moral hazard, ``To the more
specific criticism that we are engaging in moral hazard by
giving homeowners an incentive to stop paying their mortgage, I
emphasize, that is not our experience.'' Could you just
elaborate.
Mr. DiIorio. Sure. It is absolutely not our experience.
First, these sophisticated counterparties that we were speaking
about earlier, they refer these borrowers to us to be analyzed.
So the borrower is not making a conscious decision to have all
of this happen. It just kind of happens as a normal course of
business.
And our experience is--and we deal with literally hundreds
and hundreds of people--there is not this real desire for a
handout. There is a desire for a solution.
So is intentional default a real thing? It is real. It is
absolutely real, but it is very identifiable. If someone is
struggling and there is no identifiable change event that got
them to the point of struggling, that is pretty easy to see.
My personal view is that moral hazard is overplayed
politically. I just do not see it as being a real issue. It is
certainly not being talked about with the people that we are
dealing with, that is for sure.
Senator Reed. Just a final point, and then I want to go on
to Dr. Calabria and Dr. Goodman, but your analysis and your
clients' analysis is very much because of their duties to their
shareholders and to the institutions focused exclusively on the
benefits to that enterprise. But there is a broader benefit
here. For example, avoiding foreclosure in neighborhoods, that
also adds, and I think it goes to some of the failure of the
analysis of the FHFA about the systemic effects.
And just to, again, you are saying there is a business case
in the specific institutional example, but there might be even
a stronger argument when you consider the cumulative effect of
many enterprises doing that. Is that fair?
Mr. DiIorio. It is fair, and, you know, I think it is
interesting that the number that was mentioned by Senator
Menendez was 20 percent, because we find about 20 percent of
our referrals are the ones that qualify and actually make it
through. So there is probably--and I do not think that is
coincidental. So, yes, there is--and I think Dr. Goodman
referred to the just massive portfolio that Fannie and Freddie
is holding. I mean, that is clearly where the biggest impact
can be had from my perspective.
Senator Reed. Let me just skip for a moment over Dr.
Calabria to go to Dr. Goodman and just follow up on that point.
In individual business cases, Mr. DiIorio is better versed on
the case that in many times, the economics dictate reduction.
Fannie and Freddie have also the fact that the sheer size of
their portfolios, that as they began to move in this direction,
that will have effects beyond the individual properties and
even beyond their individual portfolios. Is that an accurate
assessment, in your view?
Ms. Goodman. Yes, it is.
Senator Reed. And I think you have been, Dr. Goodman, very
critical of the, just the technical analysis FHFA has done on
why they do not think principal reduction makes any sense.
Could you elaborate on what you think the--and I do not want to
be redundant. If you have covered that already, let us know.
But if you can give us sort of the top three or four points
that they have missed in your view.
Ms. Goodman. Yes. I think there were four serious technical
issues, ignoring the mortgage insurance issue and ignoring the
Treasury NPV issue, which we have already talked about.
First, they used State price level indices, not MSA level
indices, so they picked up far fewer high LTV borrowers than
there actually are, and these high LTV borrowers are aided more
by principal forgiveness than their lower LTV counterparts.
Second, and I mentioned this earlier, the results were done
on a portfolio level, not an individual loan level. So the FHFA
did not consider the possibility of following a forgiveness
strategy for some borrowers and a forbearance strategy for
others, which clearly would have dominated the use of a single
strategy.
Third, the actual HAMP program was not evaluated. That is,
the actual forgiveness in the HAMP program is the lesser of the
current LTV minus the target LTV or 31 DTI. The FHFA
automatically assumed principal reduction equal to the current
LTV minus the target LTV, so they overstated the amount of
principal reduction that would have been granted, and that
overstatement was most severe for higher-income borrowers.
And last, attributes of the loan at origination, not
current attributes, were used for the analysis. So delinquent
borrowers, on average, have suffered a deterioration in FICO
scores. By using origination characteristics, the health of the
borrowers overstated. Hence, the assumed likelihood of success
is too high, which overstates the cost of forgiveness. Those
were sort of the four technical issues.
Senator Reed. I could not have said it any better myself.
[Laughter.]
Senator Reed. Thank you, Dr. Goodman. I think what is
emerging from both your testimony and Mr. DiIorio's testimony
is that this is a tool that should be in the FHFA inventory, as
it is in the private sector, not used perhaps in every
situation, but certainly used. That is fair. I think I am
getting an affirmation there.
Dr. Calabria, again, thank you for your efforts. I know one
of the areas where you have been encouraging is REO rental, and
that is something that FHFA, to be fair, has begun a process. I
will not get into how there should be more deliberation and
speed. But that is something, I presume, that you would see as
a positive development of FHFA?
Mr. Calabria. I would. If done correctly, to be able to
speed those properties back into the marketplace, I think that
would be an important effect, and not just an effect on the
overall market, but importantly, maximizing the value of the
assets of the conservatorship.
Senator Reed. Thank you.
You know, one of the issues here, too, and it goes to the
statutory responsibility of FHFA. I know you have considered
it, Dr. Calabria. And they have repeatedly come back, we cannot
do certain things. But there is another aspect of this. We have
the Inspector General here and he has made some, based on his
analysis, conclusions essentially saying that FHFA cannot
ensure the efficiency and effectiveness of the oversight
program because they do not have the staff. FHA is overly
deferential to GSEs, that they do not try to--even though they
seem to have absolute authority over them under the
legislation, at least that is one impression, and that they are
not effectively requiring servicers to use, for want of a
better term, best practices.
To me, that seems to be a central aspect of their sort of
avowed statutory purpose of protecting the taxpayers. So if
they cannot do these things, are they falling down on their
first, primary responsibility?
Mr. Calabria. Well, let me preface with, as you know and as
I fondly remember, one of the reasons we all worked on passing
the Housing and Economic Recovery Act after three Congresses of
trying to do GSE reform was trying to deal with the staffing
issues of OFHEO, trying to deal with the undue deference.
Unfortunately, I think a lot of those aspects have remained
with FHFA.
I do think that there is a tension between having these
entities in conservatorship with the notion that they are still
private entities. I think we need to move past, quite frankly,
the fraud that they are not owned by us. We, the taxpayers, own
Freddie and Fannie. We should admit it. We should take charge
of it. And I would encourage, for instance, that we take them
into receivership. I think if we regulate it, we would have far
greater flexibility. I would also encourage that any principal
reductions or modifications that are done are passed on to the
debt holders. We are past the financial crisis in that regard.
So I do not think this needs to be passed on to the taxpayer
repeatedly. And, of course, that also maximizes the return.
But we do need to make a decision. I think it is fair to
say that FHFA lacks the staff to run these organizations from
the top and has had to rely on that, and that certainly is an
issue that needs to be fixed.
Senator Reed. A final point--and the Chairman has been very
gracious in his time--is that in the immediate weeks, months,
et cetera, action is called for, my view. And even though there
might be a more preferential form, there might be more powers
inhibiting receivership, again, working with you and your
colleagues on the legislation creating the conservator, it was
envisioned that this conservator would have some strong powers
that could require the agencies to do certain things, would, in
fact, insist that they took every reasonable step to fix it.
And when we talked to them, they say they are doing that, and
then we have an IG come in and say, well, they are not--under
their current legal mandate, not doing all that they can.
Mr. Calabria. The distinction I would draw, and I agree
that I think that their conservatorship powers are quite broad,
where I would draw the distinction is I do not believe they
allow, in my opinion, FHFA to take systemic overall marketwide
effects into account in what they do. I think that they have a
lot of flexibility in trying to preserve and conserve the
assets of the enterprises, and I think that is what they are--
so to me, for those who want to make the argument and make the
push about principal reduction, it really needs to be done in
context of you are going to preserve the assets in a better way
within that statutory framework.
I will say that I have a lot of sympathy for Mr. DeMarco in
the sense of he is not elected as you are. He is not appointed.
And I think he has tried to be very conservative in the
decisions he has made, given that he lacks the legitimacy of
someone who has actually been Senate-confirmed, and so that is
a very difficult position to be in.
Senator Reed. No, I think this is a tough, tough job for
anybody. I will be the first to say that.
Can I have a minute? Thank you. Again, the Chairman has
been very gracious.
But under the Emergency Economic Stabilization Act of 2008,
there is at least an argument that not only is there a duty to
minimize loss to the taxpayer, FHFA, there is also a
responsibility to maximize assistance for homeowners and to
minimize foreclosures and we seldom hear that in the discussion
of the FHFA. It is this drumbeat of minimizing taxpayer losses.
Do they have that, also, that dual, or at least complementary
responsibility?
Mr. Calabria. What I would say is I believe my read of the
statute is that their primary mandate is to nurse the companies
back to financial health, despite the fact that we all know
that they will never be back to a position of financial health.
Quite frankly, I think this is something that Congress
needs to be resolving. Again, there is--the ambiguities there
are beyond what would give clear guidance, in my opinion, to
the regulator.
Senator Reed. Thank you very much.
Chairman Menendez. Thank you, Senator Reed. Let me thank
all of our witnesses for sharing their expertise today.
I will just make one observation. It seems to me that there
are two ways to preserve and conserve the assets. One is
through foreclosure, and there are times in which that may be
the only reality in which the greatest preservation or
conservation of assets takes place. But when the private sector
believes that it is in their financial interest, which they
seek obviously the greatest return on the dollar--for all my
friends who are market-driven, well, here is an example of 20
percent of the market saying this is the best way for us to get
the best bottom line.
So I think in the broad context of preserving and
conserving assets, that when you have a universe within a very
large portfolio in which principal reduction can preserve and
conserve assets better than foreclosure, without looking at all
the other societal benefits, it is something they should
consider. And I hope that what we have gleaned from this
hearing is that the Government needs to be flexible enough to
adopt policies that can meet both those goals as well as
meeting some greater societal values, including maintaining the
stability and growth of both the housing market and the whole
economy, which inures to the benefit of every American.
So I have asked the FHFA to redo its analysis to take into
account the Administration's tripling of its incentives for
principal reduction, to use real data from actual principal
reductions rather than the NPV analysis alone, which seems to
have significant problems, and looking at whether there are any
differences in the outcomes between those loans that have
mortgage insurance and those that do not, and the FHFA needs to
do this all quickly and efficiently since we are already years
into the foreclosure crisis and we have not had enough adequate
answers to questions that many Members of this Committee have
posed. So again, my thanks to all of you. The record will
remain open for a week from today if any Senators wish to
submit questions for the record. We look forward to, if anyone
does, for your answers. And again, with the gratitude of the
Subcommittee, this hearing is adjourned.
[Whereupon, at 3:36 p.m., the hearing was adjourned.]
[Prepared statements supplied for the record follow:]
PREPARED STATEMENT OF JOHN C. DiIORIO
Chief Executive Officer, 1st Alliance Lending
March 15, 2012
Chairman Menendez, Ranking Member DeMint, and other Members of the
Subcommittee, I appreciate the opportunity to testify before you today.
I am the CEO of 1st Alliance Lending, a mortgage origination firm
that is a leader in originating FHA loans that offer both affordability
and principal reduction. We specialize in these loans, which reduce
principal for underwater borrowers and provide affordable monthly
mortgage payments.
There are a number of programs and loan options that have been
created in the last several years to help troubled homeowners--
including HAMP loan modifications, HARP Fannie Mae and Freddie Mac
refinancings, FHA streamlined refinancings, and assistance to
unemployed homeowners. While these programs address affordability,
generally they do not provide for principal reduction. We argue, and
our experiences substantiate, that principal reduction is critical, in
concert with affordability efforts, in providing long term solutions to
American homeowners. Moreover, we are finding that sophisticated
financial entities with their own money at risk in the mortgages are
using principal reduction in a targeted manner to maximize the recovery
value of these mortgages. There is a growing consensus that supports
these conclusions, and I appreciate the opportunity to share our
experiences on this subject.
According to Core Logic, at the end of 2011, 11.1 million homes
(over 23 percent of all homes nationwide) are underwater. A home is
underwater when the amount of the mortgage or mortgages a homeowner has
on their home exceeds the value of that home. It is hard to see how we
can address our underlying housing problems and restore health to
housing markets without addressing this issue.
Homeowners who are underwater are house-locked--unable to sell
their home should they need to move for new employment, or any other
reasons. Homeowners who are significantly underwater, particularly in
areas where housing prices are less likely to recover, face the
prospect of a very long period in which they will have no equity in
their home. HAMP and other proprietary loan modifications address
affordability problems, but even HAMP assistance phases out over time
and ultimately borrowers receiving payment modifications will continue
to be faced with the challenge of negative equity.
An often overlooked fact is that principal reduction, done
correctly and in a targeted manner, is sometimes the best economic
option for the holder of the mortgage; and often significantly enhances
the value of the asset. In fact, we increasingly see holders of
underwater mortgages utilizing principal reduction as part of their
asset maximization efforts. These are sophisticated counterparties,
acting in their own financial interest. Of course, where they utilize
this option, it is also good for the homeowner, and by extension, for
housing markets by reducing the risk of default and foreclosure.
1st Alliance Lending works with a number of major banks, investment
banks, and sophisticated financial counterparties who hold or purchase
pools of single family loans, including loans to currently distressed
and underwater borrowers. 1st Alliance analyzes these pools of loans to
identify borrowers who qualify for our programs and for whom it makes
sense financially to utilize this option. We have utilized FHA
refinance principal reduction programs, which provide opportunities for
these types of distressed homeowners to refinance their existing loan,
but only if the existing first mortgage holder forgives a portion of
the principal in order to meet FHA's loan to value (LTV) requirements.
For homeowners that qualify, we do far more than the calculations
that are done for loan modifications; we do a complete underwrite.
Unlike the typical loan modification analysis, we don't just make sure
a homeowner's loan payments are affordable, we also address subordinate
liens; often extinguishing multiple liens through our transaction. We
analyze the borrower's total debt burden and income, to make sure the
homeowner is financially sound and capable of meeting their debt
obligations. These steps are important in reducing redefault and
foreclosure risk, because modifications which focus only on the payment
affordability of the first mortgage loan do not take into account the
financial stress of other debt that the homeowner has that can
negatively impact their ability to pay their first mortgage.
Again, let me emphasize--these investors and mortgage holders that
we work with agree to principal reduction in these situations
voluntarily. Moreover, they make the decision to do principal reduction
not out of a sense of charity, but because they believe it is in their
best financial interest to do so. They are sophisticated, and are doing
these transactions to maximize asset value.
1st Alliance has been underwriting FHA loss mitigation loans long
enough that we now have a track record, with seasoned loans. From the
perspective of the FHA, I am pleased to report that our default rates
on these loans are in the single digits. This performance rate is
significantly better than original program projections for FHA
principal reduction loans, and much better than redefault rates in the
HAMP program, and we believe even better than for proprietary mods
without principal reduction. This performance, we contend, shows the
powerful impact of principal reduction.
There has been much discussion over the last few years about the
role of Net Present Value, also known as NPV, in determining which
borrowers should be candidates for any assistance, and, whether or not
to use principal reduction as part of a loan modification. I would
point out that NPV results are highly dependent on assumptions you feed
into the calculation. I would further point out that many sophisticated
market players, with their own money at risk, have made the business
decision that principal reduction does make sense for certain segments
of their portfolios. Therefore, although parties like the FHFA have
used NPV calculations to conclude that principal reduction is not
justified (in their case, for Fannie Mae and Freddie Mac loans), I
would suggest that they if they have doubts about the value of
principal reduction, they need not commit wholesale to principal
reductions, but could start by dipping their feet into the water on a
pilot or limited basis, to test out how and whether principal reduction
is effective.
Finally, I would like to address the issue of moral hazard. Moral
hazard is where individuals or firms engage in risky or careless
conduct because they are insulated from the consequences of such
conduct. Over the years, there has been extensive discussion about
Government intervention and moral hazard--during the reckless lending
period by allowing zero down and no document loans; in 2008 by bailing
out financial institutions through TARP; post crisis by helping
homeowners who have become distressed; and even now as we discuss
targeted principal reduction.
I am not here to debate the question of whether or not to help
distressed homeowners, except to note that since early 2009 we have put
in place a number of Federal programs to do so. I am here to discuss
how to help homeowners fairly and effectively. As my testimony
indicates, I believe principal reduction should be a component of any
comprehensive loss mitigation program. To the more specific criticism,
that we are engaging in moral hazard by giving homeowners an incentive
to stop paying their mortgage, I emphasize that is not our experience.
Our borrowers have experienced an objective adverse event over which
they had little or no control, such as a loss of income or a serious
health issue or problem; a true and validated hardship. None of our
borrowers are suspected of intentional default.
I am not here to advocate for beneficial loans for irresponsible
homeowners. I have come here to testify to the effectiveness of
targeted principal reduction, and its role in any responsible and
comprehensive loss mitigation strategy. I would argue that it is very
effective; and I believe the experience of my firm shows how
responsible, targeted principal reduction can not only be good for the
homeowner, the housing market, and our communities, but also good for
the holders of the existing mortgages.
Thank you again for the opportunity to testify today.
______
PREPARED STATEMENT OF MARK CALABRIA
Director of Financial Regulation Studies, Cato Institute
March 15, 2012
Chairmans Menendez and Reed, Ranking Members DeMint and Crapo, and
distinguished Members of the Subcommittees, I thank you for the
invitation to appear at today's important hearing. I am Mark Calabria,*
Director of Financial Regulation Studies at the Cato Institute, a
nonprofit, nonpartisan public policy research institute located here in
Washington, DC. Before I begin my testimony, I would like to make clear
that my comments are solely my own and do not represent any official
policy positions of the Cato Institute. In addition, outside of my
interest as a citizen, homeowner, and taxpayer, I have no direct
financial interest in the subject matter before the Committee today,
nor do I represent any entities that do.
---------------------------------------------------------------------------
* Mark A. Calabria, Ph.D., is Director of Financial Regulation
Studies at the Cato Institute. Before joining Cato in 2009, he spent 7
years as a member of the senior professional staff of the U.S. Senate
Committee on Banking, Housing, and Urban Affairs. Prior to his service
on Capitol Hill, Calabria served as Deputy Assistant Secretary for
Regulatory Affairs at the U.S. Department of Housing and Urban
Development, and also held a variety of positions at Harvard
University's Joint Center for Housing Studies, the National Association
of Home Builders and the National Association of Realtors. He has also
been a Research Associate with the U.S. Census Bureau's Center for
Economic Studies. He holds a doctorate in economics from George Mason
University. http://www.cato.org/people/mark-calabria
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Some Observations on Our Mortgage Market
Policy options should be informed by facts. A few facts, which I
believe are directly relevant to the state of our mortgage markets,
particularly the trend in foreclosures and delinquencies are as
follows:
The vast majority of underwater borrowers are current on
their mortgages. Even the majority of deeply underwater
borrowers are current. For prime borrowers with loan-to-values
(LTV) over 125 percent, over 75 percent are current. Over half
of deeply underwater subprime borrowers are current. (Fitch)
GSE underwater borrowers are also preforming, with almost
80 percent current. The GSEs' book of underwater loans has
actually seen the percent current increasing over the last
year.
GSE loans display a smaller percentage (9.9 percent)
underwater than loans in private label securities (35.5 percent
underwater).
According to Fannie Mae's National Housing Survey only
about 10 percent surveyed believed it was appropriate for
underwater borrowers to simply ``walk away.'' While higher than
I would prefer, this does indicate that the risk of widespread
strategic default is limited.
Credit quality of the borrower continues to be the primary
predictor of default. For borrowers with FICOs in excess of
770, of those deeply underwater (125 percent LTV) 85 percent
are still current. (Fitch)
About a fifth of subprime borrowers who have significant
equity (LTV < 80 percent) are 60 or more days delinquent.
Clearly their situation has nothing to do with equity, and
everything to do with borrower credit quality. (Fitch)
Total delinquencies are down over 25 percent from the peak
in January 2010, having declined from 10.97 percent to 7.97
percent in January 2012. (LPS)
Over 40 percent of loans in foreclosure are over 2 years
past due. These loans will likely never cure. Only 19 percent
of loans in foreclosure are less than 8 months past due. No one
can say, with a straight face, that foreclosures, in general,
are happening ``too fast.''
Almost half of loans, currently entering foreclosure, were
previously in foreclosure, that is they are ``repeat
foreclosures.'' (LPS)
The rate of new problem loans, those newly seriously
delinquent that were current 6 months previous, peaked in
Spring 2009, when the economy was hitting bottom, and have been
steadily declining since.
Including distressed transactions, the peak-to-current
change in the national HPI (from April 2006 to January 2012)
was -34.0 percent. Excluding distressed transactions, the peak-
to-current change in the HPI for the same period was -24.2
percent. (CoreLogic)
The last point is particularly relevant, as the number of
underwater borrowers greatly depends upon current home values. If home
values are based upon distressed transactions, then the number of
underwater borrowers would be far greater than if one excludes
distressed sales. There is some reason to believe the distressed sales
are not representative of the overall market, for instance they are
likely to have seen greater physical deterioration.
State of the Housing Market
The U.S. housing market remains weak, with both homes sales and
construction activity considerably below trend. Despite sustained low
mortgage rates, housing activity has remained sluggish in 2011.
Although construction activity picked up in 2001, housing starts are
still below half the levels seen in 2007. In fact I believe it will be
at least until 2015 until we see construction levels approach those of
the boom. In addition to the 4.7 percent decline in existing home
prices in 2011, we are likely to see additional, but small, declines in
2012. Consensus estimates run around a 3 percent decline in home prices
for 2012.
Housing permits, on an annualized basis, increased 0.7 percent from
December 2010 to January 2011 (671,000 to 676,000). Permits for both
single family units and permits for larger multifamily properties (5+
units) increased slightly, but permits for smaller multifamily units
fell 4.2 percent. Single family permits increased from 441,000 to
445,000 in December. Permits for 2-4 unit properties fell (24,000 to
23,000) in January. Permits for 5+ units climbed to 206,000 in January
from 204,000 in December.
According to the Census Bureau, January 2012 housing starts were at
a seasonally adjusted annual rate of 699,000, up slightly from the
December level of 689,000. Overall starts are up, on an annualized
level, from 2011's 610,700 units. This increase, however, is mostly
driven by a jump in multifamily starts, as single-family starts
decreased slightly. Total residential starts continue to hover at
levels around a third of those witnessed during the bubble years of
2003 to 2004.
As in any market, prices and quantities sold in the housing market
are driven by the fundamentals of supply and demand. The housing market
faces a significant oversupply of housing, which will continue to weigh
on both prices and construction activity. The Federal Reserve Bank of
New York estimates that oversupply to be approximately 3 million units.
Given that annual single family starts averaged about 1.3 million over
the last decade, it should be clear that despite the historically low
current level of housing starts, we still face a glut of housing. NAHB
estimates that about 2 million of this glut is the result of ``pent-
up'' demand, leaving at least a million units in excess of potential
demand. \1\ Add to that another 1.6 million mortgages that are at least
90 days late. My rough estimate is about a fourth of those are more
than 2 years late and will most likely never become current.
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\1\ Denk, Dietz, and Crowe, ``Pent-up Housing Demand: The
Household Formations That Didn't Happen--Yet'', National Association of
Home Builders. February 2011.
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The Nation's oversupply of housing is usefully documented in the
Census Bureau's Housing Vacancy Survey. The boom and bust of our
housing market has increased the number of vacant housing units from
15.6 million in 2005 to a current level of 18.4 million. The rental
vacancy rate for the 4th quarter of 2011 declined to 9.4 percent after
increasing to 9.8 percent the previous quarter, although this remains
considerably above the historic average. The decline in rental vacancy
rates over the past year has been driven largely by declines in
suburban rental markets. The vacancy rate for newly constructed rental
units is approaching the rate for old construction, but for newly
constructed homeowner units it remains considerably higher than old
construction.
The homeowner vacancy rate, after increasing from the 2nd and 3rd
quarters of 2010 to the 4th quarter of 2010, declined slowly over the
year 2011 to reach 2.3 percent last quarter, a number still in
considerable excess of the historic average.
The homeowner vacancy rate, one of the more useful gauges of excess
supply, differs dramatically across metro areas. At one extreme,
Greensboro, NC, has an owner vacancy rate of well over 6 percent,
whereas El Paso, Texas, has a rate of 0 percent. Other metro with
excessive high owner vacancy rates include: Dayton, OH (6.2); Las Vegas
(5.5); Columbia, SC (5.1); New Orleans (4.6); and Phoenix (3.6).
Relatively tight owner markets include: Albany, NY (0.0); Norwalk, CT
(0.2); and Tucson, AZ (0.3).
The number of vacant for sale or rent units has increased, on net,
by around 3 million units from 2005 to 2011. Of equal concern is that
the number of vacant units ``held off the market'' has increased by
about 1.5 million since 2005. In all likelihood, many of these units
will re-enter the market once prices stabilize.
The 4th quarter 2011 national home ownership rate fell to 66.0
percent, which is approximately where it was in 1997, effectively
eliminating all the gain in the home ownership rate over the last 12
years. Declines in the home ownership rate were the most dramatic for
the youngest homeowners, while home ownership rates for those 55 and
over were generally stable or even increasing. This should not be
surprising given that the largest increase in home ownership rates was
among the younger households and that such households have less
attachment to the labor market than older households. Interestingly
enough, the decline in home ownership was higher among households with
incomes above the median than for households with incomes below the
median, which held steady.
Home ownership rates declined across the all Census Regions except
for the Northeast (which held steady), the steepest decline was in the
West, followed by the Midwest. The South witnessed the smallest decline
in home ownership since the bursting of the housing bubble.
Homeowner vacancy rates differ dramatically by type of structure,
although all structure types exhibit rates considerably above historic
trend levels. For 4th quarter 2011, single-family detached homes
displayed an owner vacancy rate of 2.0 percent, while owner units in
buildings with 10 or more units (generally condos or co-ops) displayed
an owner vacancy rate of 8.3 percent. Although single-family detached
constitute 95 percent of owner vacancies, condos and co-ops have been
impacted disproportionately. Over the last year homeowner vacancy rates
have declined slightly for single-family structures but more
dramatically for condos or co-ops, albeit from a much higher level.
Owner vacancy rates tend to decrease as the price of the home
increases. For homes valued between $100,000 and $150,000 the owner
vacancy rate is 2.5 percent, whereas homes valued over $200,000 display
vacancy rates of about 1.3 percent. The clear majority, almost 63
percent, of vacant owner-occupied homes are valued at less than
$300,000. Owner vacancy rates are also the highest for the newest
homes, with new construction displaying vacancy rates twice the level
observed on older homes.
While house prices have fallen considerably since the market's peak
in 2006--over 23 percent if one excludes distressed sales, and about 31
percent including all sales--housing in many parts of the country
remains expensive, relative to income. At the risk of
oversimplification, in the long run, the size of the housing stock is
driven primarily by demographics (number of households, family size,
etc.), while house prices are driven primarily by incomes. Due to both
consumer preferences and underwriting standards, house prices have
tended to fluctuate at a level where median prices are approximately 3
times median household incomes. Existing home prices, at the national
level, are close to this multiple. In several metro areas, however,
prices remain quite high relative to income. For instance, in San
Francisco, existing home prices are almost 8 times median metro
incomes. Despite sizeable decline, prices in coastal California are
still out of reach for many families. Prices in Florida cities are
generally above 4 times income, indicating they remain just above long-
run fundamentals. In some bubble areas, such as Phoenix and Las Vegas,
prices are below 3, indicating that prices are close to fundamentals.
Part of these geographic differences is driven by the uneven impact of
Federal policies.
Household incomes place a general ceiling on long-run housing
prices. Production costs set a floor on the price of new homes. As
Professors Edward Glaeser and Joseph Gyourko have demonstrated, \2\
housing prices have closely tracked production costs, including a
reasonable return for the builder, over time. In fact the trend has
generally been for prices to about equal production costs. In older
cities, with declining populations, productions costs are often in
excess of replacement costs. After 2002, this relationship broken down,
as prices soared in relation to costs, which also included the cost of
land. \3\ As prices, in many areas, remain considerably above
production costs, there is little reason to believe that new home
prices will not decline further.
---------------------------------------------------------------------------
\2\ Edward Glaeser and Joseph Gyourko, ``The Case Against Housing
Price Supports'', Economists' Voice, October 2008.
\3\ Also see, Robert Shiller, ``Unlearned Lessons From the Housing
Bubble'', Economists' Voice, July 2009.
---------------------------------------------------------------------------
It is worth noting that existing home sales in 2010 were only 5
percent below their 2007 levels, while new home sales are almost 60
percent below their 2007 level. To a large degree, new and existing
homes are substitutes and compete against each other in the market.
Perhaps the primary reason that existing sales have recovered faster
than new, is that price declines in the existing market have been
larger. Again excluding distressed sales, existing home prices have
declined 23 percent, whereas new home prices have only declined only
about 10 percent. I believe this is clear evidence that the housing
market works just like other markets: the way to clear excess supply is
to reduce prices.
State of the Mortgage Market
According to the Mortgage Bankers Association's National
Delinquency Survey, the delinquency rate for mortgage loans on one-to-
four-unit residential properties decreased to a seasonally adjusted
rate of 7.58 percent of all loans outstanding for the end of the 4th
quarter 2011, 41 basis points down from 3rd quarter 2011 and down 67
basis points from 1 year ago.
The percentage of mortgages on which foreclosure proceedings were
initiated during the fourth quarter was 0.99 percent, 9 basis points
down from 2011 Q3 and down 28 basis points from 2010 Q4. The percentage
of loans in the foreclosure process at the end of the 4th quarter was
4.38 percent, down slightly at 5 basis points from 2011 Q3 and 26 basis
points lower than 2010 Q4. The serious delinquency rate, the percentage
of loans that are 90 days or more past due or in the process of
foreclosure, was 7.73 percent, a decrease of 16 basis points from 2011
Q3, and a decrease of 87 basis points from 2010 Q4.
The combined percentage of loans in foreclosure or at least one
payment past due was 12.53 percent on a nonseasonally adjusted basis, a
10 basis point decrease from 2011 Q3 and 107 basis points lower than
2010 Q4.
Extent of Negative Equity
Despite that the vast majority of underwater borrowers continue to
pay their mortgages, concerns about negative equity dominate policy
debates surrounding the mortgage market. According to CoreLogic, 11.1
million, or 22.8 percent, of all residential properties with a mortgage
(recall that about a third of owners own their homes free and clear)
are in a negative equity position. This situation is highly
concentrated in terms of geography. The top five States (NV, AZ, FL,
MI, and GA) display an average negative share of 44.3 percent. The
remaining States have a combined average negative share of 15.3
percent. Any taxpayer efforts to reduce negative equity would largely
be a transfer from the majority of States to a very small number.
Of those with negative equity, 4.4 million have both first and
second mortgages. The average LTV of these borrowers is 138 percent,
implying that in the event of a foreclosure, the second lien would
likely have little, if any value. Efforts to modify first liens only,
or to modify firsts and seconds in proportion, are, in effect, transfer
from the first lien holder to the second. We should reject such
transfers, as they violate the basic principles of contract and
property, and require all seconds to be eliminated before any loss are
taken on first liens.
While less than half of those with negative equity have second
liens, those that do constitute a far greater share of negative equity
borrowers. Those with both first and second liens display a negative
equity share of 39 percent, twice that for borrowers with a first lien
only. Of the estimated $717 billion in negative equity just over half
is from borrowers with both first and second liens. My estimate is that
about a fourth of negative equity is in the form of second liens.
For pressing importance for policy makers is the fact that just
under 2 million FHA borrowers are underwater. The vast majority of
these borrowers took out mortgages since the beginning of the housing
bust. Just under a third of all FHA borrowers that took loans out since
the housing bust are now underwater. That giving borrowers near-zero
equity loans in a deflating housing market would result in widespread
negative equity should have been obvious (it was to me), but that is of
course ``water under the bridge.'' The important issue now is
mitigating that risk. As FHA's 203(b) program does have the power of
full recourse, I urge FHA to advertise that power and implement
programs to exercise it. In addition delinquent FHA borrowers should be
reported immediately the to IRS, so that any tax refunds can be used
instead to off-set losses to the taxpayer. My estimates are that FHA is
likely to require between $10 and $50 billion over the next 5 to 6
years in order to honor all claims.
New York Federal Reserve Study
An August 2010 study by economists at the Federal Reserve Bank of
New York has generated considerable interest as a road-map for reducing
mortgage defaults. \4\ Specifically the study has been used to argue
for increased principal reduction as a way to reduce defaults. While
the study has a number of flaws, for instancing assuming that all
redefaults only occur within 12 months of a modification, the study
does take the appropriate approach in examining borrower incentives.
The study correctly treats borrowers as choosing to default, rather
than modeling default as something that simply ``happens'' to the
borrower. The impact of principal reduction is also relative small,
lower the author's estimated 12 month redefault rate of 56 percent by
4.5 percent to 51.5 percent. So even if we adopted the author's
proposal, over half of modified loans would still redefault.
---------------------------------------------------------------------------
\4\ Andrew Haughwout, Ebiere Okah, and Joseph Tracy, ``Second
Chances: Subprime Mortgage Modifications and Re-Default'', Federal
Reserve Bank of New York Staff Reports no. 417. August 2010.
---------------------------------------------------------------------------
Not surprisingly proponents of principal reduction are choosing
which parts of this study they like and discarding the parts they do
not. For instance the study finds that ``each additional month that a
borrower can expect to live rent-free in the house increases the 12
month redefault rate by 0.6 percentage points.'' To put that in
perspective, the difference in the overall foreclosure process between
judicial States and nonjudicial foreclosure States in about 18 months.
At 0.6 percentage points a month, if judicial States switched to an
administrative process, redefault rates would decline by an estimated
10.8 percentage points or twice the impact one gets from a 10 percent
reduction in principal. States with allow recourse have redefault rates
that are 1.8 percentage points lower. Interestingly enough the authors
find that the lower are area house prices, compared to their 2000
values, the lower are redefault rates. Attempts to keep prices above
their pre-bubble rates have, to some extent, increased defaults. The
logic is that a borrower's decision to default is based not solely on
current equity but also on the expected path of future home prices. If
we can get to the bottom, which I believe we are nearing, then
borrowers will have greater incentives to maintain their mortgage.
If You Are Going To Modify . . .
While I remain quite skeptical of many of the efforts at mortgage
modification, as most seem aimed at dragging out the problem and
avoiding the inevitable correction of the housing market, if we are
going to continue offering modifications to delinquent and/or
underwater borrowers, we should include the following provisions:
All modifications should include and exercise recourse.
Modifications should be limited to those have been current
at some point within the previous year.
Modifications should be targeted to those who display a
``willingness to pay'' but lack the ability to do so.
Current modification programs have often been inspired by the
creation of the Home Owners Loan Corporation (HOLC) in 1933, which
refinanced borrowers into ``affordable'' long term loans. Apparently
the nostalgia for the HOLC has encouraged an ignorance of its actual
workings. The HOLC practiced aggressive recourse, for instance. So much
so that a third of its total revenues were derived from deficiency
judgments. The HOLC also limited assistance to creditworthy borrowers
who demonstrated a willingness to pay. If we wish to mimic the claimed
success of the HOLC than we also need to understand how it functioned.
\5\
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\5\ See, C. Lowell Harriss, ``History and Policies of the Home
Owners' Loan Corporation'', National Bureau of Economic Research, 1951.
http://www.nber.org/books/harr51-1
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There are some reports that the recent robo-signing settlement with
give banks up to $1.7 billion in credit against the overall settlement
if they waive their right to pursue deficiency judgments. \6\ The
empirical literature is fairly robust on this point: the existence of
deficiency judgments reduces foreclosures. This aspect of the
settlement will likely increase foreclosures.
---------------------------------------------------------------------------
\6\ Nick Timiraos, ``Mortgage Deal Built on Tradeoffs'', Wall
Street Journal, Monday, March 12, 2012, C1.
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What's a Conservator For?
Criticism has been directed at FHFA for not either allowing or
forcing Fannie Mae and Freddie Mac to engage in principal reductions.
Much of this criticism has take the form of claims that the GSEs, and
hence FHFA, are not ``doing enough'' to turn around the housing market.
Blogger Matt Yglesias suggests that ``clearly the purpose of creating
the FHFA and taking Fannie and Freddie into conservatorship can't have
been to minimize direct taxpayer financial losses on agency debt.''
This claim, and others like it, are mistaken. The Housing and Economic
Recovery Act (HERA) of 2008 is quite clear when it comes to the duty
and responsibilities of FHFA when acting as a conservator.
A simple read of the statute, Section 1145 of HERA, which amends
Section 1367 of the 1992 GSE Act, clearly states the purpose, duties,
and role of a conservatorship. What does the law say the powers of a
conservatorship are? They are to ``take such action as may be--(i)
necessary to put the regulated entity in a sound and solvent condition;
and (ii) appropriate to carry on the business of the regulated entity
and preserve and conserve the assets and property of the regulated
entity.''
Some proponents of principal reduction have found language
elsewhere in HERA which they believe allows for considerations beyond
those found in Section 1145. But this argument relies on general
introductory sections of the statute, not the powers and duties of FHFA
as a conservator. Statutory interpretation requires that more specific
sections trump general introductory sections. General sections have
``no power to give what the text of the statute takes away'' (Demore v.
Kim, 538 U.S. 510, 535).
Given FHFA's estimate that a broad based program of principal
reduction would cost almost $100 billion, the argument that an
unelected, unappointed, acting agency head should, in the absence of
statutory authority, spend $100 billion on taxpayer money is simply
inconsistent with our system of Government. While agencies such as the
Federal Deposit Insurance Corporation felt free to violate the law
during the crisis, Acting FHFA Director DeMarco should be commended for
his faithfulness to the letter of the law. If $100 billion of taxpayer
dollars is to be spent on principal reduction, it is the responsibility
of Congress to make that decision. To suggest this action be
implemented without Congressional approval would only further erode the
already diluted powers of Congress relative to the other branches of
Government. Members had the opportunity during the passage of HERA to
increase the powers and duties of FHFA as conservator. Congress decided
not to.
The Problem Is Mortgage Availability
The problem facing our housing market is a combination of weak
demand and excess supply. All policy proposals should first be
evaluated on that basis. One of the constraints on demand is mortgage
availability. If one is a prime borrower, who can make a substantial
down payment, then mortgages are both cheap and plentiful. If one is
not, then a mortgage is difficult, if not impossible to get.
This decline in mortgage availability derives from a variety of
factors, some good, some bad. For instance the most irresponsible
lending, with the exception of FHA, is gone (for how long, who knows).
That is a good thing. Unfortunately much of the Alt-A and higher
quality subprime lending is also gone. That is not such a good thing.
By my estimate about a fifth of the mortgage market has disappeared,
holding back housing demand. One of the factors contributing to that
disappearance is the combination of Federal Reserve interest rate
policy with Federal mortgage regulation. For instance under HOEPA,
today any mortgage over 5.5 percent is considered ``high-cost.'' Such
mortgages now carry considerable regulatory, reputation, and litigation
risk. Anyone with just a basic knowledge of financial history knows
that 5.5 is, historically speaking, a great rate, not a predatory one.
Charts, at the end of this testimony, display the distribution of
mortgages rates charged in 2006 and 2011. It should be immediately
clear that 2006 largely resembled a normal distribution. 2011, however,
has seen the right side of that distribution largely eliminated.
Clearly the distribution of mortgage rates in 2011 is near normal nor
symmetric. I believe the Federal Reserve's 2008 HOEPA regulation has
contributed to this abnormality. Of course there are other factors,
again some good, some bad.
Foreclosure Mitigation and the Labor Market
There is perhaps no more important economic indicator than
unemployment. The adverse impacts of long-term unemployment are well
known, and need not be repeated here. Although there is considerable,
if not complete, agreement among economists as to the adverse
consequences of jobless; there is far less agreement as to the causes
of the currently high level of unemployment. To simplify, the differing
explanations, and resulting policy prescriptions, regarding the current
level of unemployment fall into two categories: (1) unemployment as a
result of lack of aggregate demand, and (2) unemployment as the result
of structural factors, such as skills mismatch or perverse incentives
facing the unemployed. As will be discussed below, I believe the
current foreclosures mitigation programs have contributed to the
elevated unemployment rate by reducing labor mobility. The current
foreclosures mitigation programs have also helped keep housing prices
above market-clearing levels, delaying a full correction in the housing
market.
First we must recognize something unusual is taking place in our
labor market. If the cause of unemployment was solely driven by a lack
of demand, then the unemployment rate would be considerably lower. Both
GDP and consumption, as measured by personal expenditures, have
returned to and now exceed their precrisis levels. But employment has
not. Quite simply, the ``collapse'' in demand is behind us and has been
so for quite some time. What has occurred is that the historical
relationship between GDP and employment (which economists call ``Okun's
Law'') has broken down, questioning the ability of further increases in
spending to reduce the unemployment rate. Also indicative of structural
changes in the labor market is the breakdown in the ``Beveridge
curve''--that is the relationship between unemployment and job
vacancies. Contrary to popular perception, job postings have been
steadily increasing over the last year, but with little impact on the
unemployment rate.
Historically many job openings have been filled by workers moving
from areas of the country with little job creation to areas with
greater job creation. American history has often seen large migrations
during times of economic distress. And while these moves have been
painful and difficult for the families involved, these same moves have
been essential for helping the economy recover. One of the more
interesting facets of the recent recession has been a decline in
mobility, particular among homeowners, rather than an increase. Between
2008 and 2009, the most recent Census data available, 12.5 percent of
households moved, with only 1.6 moving across State lines.
Corresponding figures for homeowners is 5.2 percent and 0.8 percent
moving across State lines. This is considerably below interstate
mobility trends witnessed during the housing boom. For instance from
2004 to 2005, 1.5 percent of homeowners moved across State lines,
almost double the current percentage. Interestingly enough the overall
mobility of renters has barely changed from the peak of the housing
bubble to today. This trend is a reversal from that witnessed after the
previous housing boom of the late 1980s burst. From the peak of the
bubble in 1989 to the bottom of the market in 1994, the percentage of
homeowners moving across State lines actually increased.
The preceding is not meant to suggest that all of the declines in
labor mobility, or increase in unemployment, is due to the foreclosure
mitigation programs. Far from it. Given the many factors at work,
including the unsustainable rate of home ownership, going into the
crisis, it is difficult, if not impossible, to estimate the exact
contribution of the varying factors. We should, however, reject
policies that encourage homeowners to remain in stagnant or declining
labor markets. This is particularly important given the fact that
unemployment is the primary driver of mortgage delinquency.
Minimizing Losses to Taxpayers
As the title of today's hearing implies an important objective of
policy should be to protect the taxpayer from further loss. We should
never forget that the taxpayer has already poured $180 billion in the
rescue of Fannie Mae and Freddie Mac. It is unlikely that much, if any,
of this will ever be recovered. In addition the taxpayer potentially
faces the cost of rescuing the Federal Housing Administration (FHA). I
believe there is a significant likelihood that the taxpayer will have
to inject somewhere between $10 to $50 into FHA over the next 5 to 6
years.
The most effective way to protect the taxpayer would be to simply
stop. Stop covering the losses of Fannie Mae and Freddie Mae and do not
impose policies that would dig the current hole any deeper. We are well
past the height of the financial panic. And as the recent mortgage
settlement demonstrated, policy makers appear to have no problem with
imposing losses on investors. The same should be applied to Fannie Mae
and Freddie Mae. Future losses should be borne by the debt-holders of
those companies, not the taxpayer. Accordingly Fannie Mae and Freddie
Mac should be moved immediately out of conservatorship and into
receivership, where losses can be imposed upon those investors who
willingly risked their own money (the same cannot be said for the
taxpayer).
As FHFA estimates that a program of principal forgiveness for all
underwater GSE mortgages could cost as much as $100 billion, it should
be very clear that such would not minimize losses to the taxpayer.
Summary of Policy Proposals
Repeal/Suspend/Modify Existing HOEPA Regulations.
Require recourse for all federally related modifications.
End programs, like ``Neighborhood stabilization,'' that add
to housing supply. If spending, use such to increase demand,
not supply.
Reform FHA to minimize embedded losses.
Conclusion
The U.S. housing market is weak and is expected to remain so for
some time. Given the importance of housing in our economy, the pressure
for policy makers to act has been understandable. Policy should,
however, be based upon fostering an unwinding of previous unbalances in
our housing markets, not sustaining said unbalances. We cannot go back
to 2006, and nor should we desire to. As the size and composition of
the housing stock are ultimately determined by demographics, something
which policy makers have little influence over in the short run, the
housing stock must be allowed to align itself with those underlying
fundamentals. Prices should also be allowed to move towards their long
run relationship with household incomes. Getting families into homes
they could not afford was a major contributor to the housing bubble. We
should not seek to repeat that error. We must also recognize that
prolonging the correction of the housing market makes the ultimate
adjustment worse, not better. Lastly it should be remembered that one
effect of boosting prices above their market-clearing levels is the
transfer of wealth from potential buyers (renters) to existing owners.
As existing owners are, on average, wealthier than renters, this
redistribution is clearly regressive.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
PREPARED STATEMENT OF LAURIE S. GOODMAN
Senior Managing Director, Amherst Securities
March 15, 2012
Chairman Menendez and Members of the Subcommittee, I thank you for
your invitation to testify today. My name is Laurie Goodman, and I am a
Senior Managing Director at Amherst Securities Group, LP, a leading
broker/dealer specializing in the trading of residential and commercial
mortgage-backed securities. We are a market maker and intermediary in
these securities, dealing with many of the largest financial
institutions, insurance companies, money managers and hedge funds. I am
in charge of the Strategy effort, which performs extensive, data-
intensive studies as part of our efforts to keep ourselves and our
customers informed of critical trends in the residential mortgage-
backed securities market.
In my testimony today, I will discuss three actions that can
strengthen the mortgage market, at no or minimal cost to taxpayers:
increasing reliance on principal reduction modifications; a ramp up of
the bulk sales program, coupled with financing for these properties;
and a careful vetting of new rules that affect already tight credit
availability.
Sizing the Challenge
As we look across the U.S. housing landscape, our empirical studies
have convinced us that there are a huge number of borrowers (7.4-9.3
million) yet to face foreclosure and eventual liquidation. The expected
liquidations break down into the following categories:
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Thus, if we stay on the present course, of the 52.5 million total
U.S. homes with a mortgage, 14.1 17.7 percent, or 7.4-9.3 million of
these borrowers face foreclosure and eventual liquidation. To absorb
this large number of housing units that will face foreclosure and
eventual liquidation, we need to both limit the supply of AND increase
the demand for distressed properties. To limit supply, we need more
successful loan modifications. For this, we believe increased reliance
on principal reduction is the key. To increase demand, we need a
successful bulk sales program to bring institutional investors into the
housing market. We also need broader credit availability standards, yet
every single governmental action that is being considered seems to
further constrain credit availability.
Most of my testimony will be focused on supply side measures;
namely, improving modification success through greater reliance on
principal reductions. Then I will take up demand side measures. I will
touch upon the new Government program to sell single family properties
to investors (for turning into rental units; a program we believe will
be ultimately very successful). Finally, I will delve into the negative
impact of constrained credit availability, and my concern about
impending regulations that will exacerbate this issue. All of my
recommendations in this testimony (expanded use of principal
reductions, the bulk sales program, and fully vetting the impact of new
rules or guidelines that affect credit availability) require very
limited use of taxpayer money.
Why Investors Support Modification Activity
Modification success has improved dramatically over time. In
private label (nonagency residential mortgage) securitizations, for
modifications performed during the first half of 2011, the average
redefault rate after 12 months is down to 30 percent, versus 70 percent
performed during the first half of 2009. The improved results reflect
two factors: (1) the way modifications are counted has changed, which
has improved reported success rates, and (2) modifications have become
much more significant, increasing the appeal to borrowers remaining in
the home. This has genuinely improved success rates.
1. Change in modification count methodology--There was no trial
period for modifications completed in early 2009 and earlier.
The modification was ``counted'' the minute it was initiated,
yet many modifications failed in the first 3 months, which
boosted the failure rate of those early modifications. The
trial period was introduced as part of the HAMP program, and
was quickly adopted for proprietary modifications.
2. Modifications have become more significant over time--The HAMP
modification program has been important in that it provided a
blueprint for significant pay relief for the borrower. And
modifications that provide more significant relief have
resulted in much lower redefault rates than earlier
modifications that did not.
It's the investors in private label securitizations who bear the
cost of any modification on those securities, be it a principal
reduction or an interest rate decrease. However, investors in private
label securitizations have been very supportive of modification
efforts. Why? Investors recognize that foreclosure is both the worst
outcome for the borrower AND the investor. A simple example in Exhibit
1 (next page) makes this argument concrete. The data in the exhibit are
real, drawn from the universe of private label securities that were
liquidated in the past month. The average loan balance is $279,184, but
if we marked these homes to market, the current market value of the
homes averaged only $227,046 (thus ``underwater'' with a loan-to-value
ratio of 123 percent) due to price depreciations on the properties. If
the property were liquidated the investor would not realize that market
value of $227,046, since homes in foreclosure usually sell at a
discount. The investors should have realized a gross recovery, net of
broker commission, on the property of $173,591 (amounting to a 62.2
percent of the current loan balance, or 76 percent of current market
value). Furthermore, there are other costs to subtract from the sale
proceeds due the investor, arising from the borrower having been, on
average, 26 months delinquent at liquidation. These costs are sizeable;
advances for tax and insurance total $21,927 and other direct costs
associated with foreclosure and liquidations total $7,452. Finally,
every day a house remains in nonperforming status, with either a
homeowner who is not maintaining the property, or the home sitting
vacant--the property is deteriorating. We estimate that the
deterioration factor decreases property value by another $13,842 over
the 26-month average period of delinquency. These costs are all
captured in Exhibit 1. Note that collectively an investor nets $130,370
($173,591 $43,221), for a 46.7 percent net recovery (or a 53.3 percent
loss per loan balance). The recovery to the investor in private label
securitizations will be even lower, because, upon the liquidation of
the trust, the servicer will be reimbursed for any payments of
delinquent principal and interest that he has made to the trust.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
An investor would be far better off if a substantial payment
reduction had been offered to the borrower, to reduce the loan payment
to an affordable level, rather than going through foreclosure and
liquidation (and the investor ending up with only 46.7 percent of the
loan being repaid). If the borrower were offered a principal reduction
to 100 percent of the current market value of the home ($227,046) and
was able to make the payments associated with this loan, both the
borrower and the investor would be much better off. The investor now
has a loan worth $227,046 rather than $130,370.
My representation that investors are in favor of modifications is
not to say that there is no room for improvement--there is. Here are
some of the most important weaknesses from the point of view of
investors:
Servicers are in charge of performing the modification. But
they are massively conflicted, as they often own the second
lien on the same property, but service both the first lien and
the second lien. We believe that special servicers, who
specialize in dealing with nonperforming loans, are apt to
demonstrate a track record for better modification success, as:
(1) they are not in a position of conflict; and (2) they can
review the full range of alternatives in order to maximize the
value of the loan, not just whether a given modification is
better than foreclosure (which sets a low bar for a standard of
delivering final proceeds to settle a loan, as illustrated
above).
A modification considering the borrower's total debt
situation (including second liens, credit cards, auto loans,
etc., which are often collectively referred to as ``back-end
debt-to-income ratio'') will be more successful than one only
considering the payments on the first lien, plus taxes and
insurance (the ``front-end debt-to-income ratio''). In fact, we
believe the best way to have structured the modification
program was to re-underwrite the loan for sustainability, while
respecting lien priority. In many cases, this means the second
lien would be written off entirely, and the first lien would be
resized. In a more optimal world other debts would also be
resized.
Re-equifying the borrower is critical. Borrowers who are
deeply underwater are less likely to commit to a successful
modification. This suggests that principal reductions should be
more effective than other types of modifications (rate
modifications or capitalization modifications)--and they are
proving to be so.
It is important to take a step back and outline the three basic
modification types: principal balance modifications, rate
modifications, and capitalization modifications. In a principal
modification, the principal balance is reduced. This can take the form
of principal forbearance (deferral), in which the borrower still owes
the money, but does not pay interest on it, and principal forgiveness,
in which the borrower does not owe the money. In a rate modification,
the interest rate is reduced. In a capitalization modification, neither
the interest rate nor the principal balance is reduced, but the term
may be extended to reduce the payment.
Principal Reduction Is the Most Effective Form of Modification
It has become increasingly common to modify principal balances
rather than just modifying the rate and term on a mortgage. For
example, in 2009 for private label securities, only 5 percent of
modifications were principal modifications, whereas now a full 32
percent are. The reason is that this is the most effective type of
modification.
While available data on private label securities does not allow us
to distinguish forgiveness from forbearance modifications, the OCC/OTS
report \1\ does. It provides some very interesting numbers, based on
information reported by the largest servicers. The data shows the types
of modifications that were received, sorted by the bearer of the risk.
Note that each column adds to more than 100 percent, as more than one
type of action is generally taken in a modification. Thus, a servicer
may recapitalize delinquent balances, reduce the rate, and extend the
term (length to maturity) of the loan. Or--they may recapitalize the
delinquent balances, and forgive (reduce) the balance or forbear
(defer) the principal.
---------------------------------------------------------------------------
\1\ OCC Mortgage Metrics Report--Third Quarter 2011, Office of the
Comptroller of the Currency/Office of Thrift Supervision, dated 12/21/
2011.
---------------------------------------------------------------------------
Look first at the data from Q4 2010 (left side, Exhibit 2, next
page). Note that banks were doing principal reduction solely for their
own portfolio (17.8 percent of banks' own portfolio loans received a
reduction), but few loans serviced by the banks for others received
principal reductions. By Q3 2011 (the most recent data available, shown
on the right side of Exhibit 2), banks were doing principal reduction
both for their own portfolio (18.4 percent of the loans) as well as for
loans serviced on behalf of private label investors (15.3 percent of
the loans). Note that the share that received reduction on loans
insured by Fannie Mae, Freddie Mac, or the U.S. Government is zero, as
servicers are not permitted to do principal reduction on these loans.
The bottom part of the table in Exhibit 2 shows that the success rate
on banks' portfolio loans is better than that on loans serviced for
others. We would really like to know the success rate on principal
reduction modifications versus other types of modifications
(controlling for other characteristics, of course) but this information
is not disclosed.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Moreover, our discussions with individual servicers show that they
are increasingly relying on principal forgiveness. Under HAMP,
servicers are required to test a borrower for a modification using the
regular HAMP waterfall (first reduce the interest rate, then extend the
term, then forbear principal) and the principal reduction alternative
(first forgive principal, then reduce the interest rate, then extend
the term, then forbear principal). However, if the principal reduction
alternative has a higher net present value (NPV) they are not required
to use it. In May 2011, Bank of America announced that when the NPV
test showed the superiority of the principal reduction alternative,
they will start using it. And we see that the number of Bank of America
serviced loans receiving principal modifications is up sharply since
then. We also see large increases in the number of principal
modifications on Chase- and Ocwen-serviced loans.
At Amherst, we have done extensive empirical work and shown that
there are 3 determinants of modification success:
1. The amount of pay relief is important.
2. The number of months delinquent at the time of modification is
quite important. If you offer a borrower a modification with 30
percent pay relief at the point when the loan is 2 months
delinquent, the borrower is apt to regard that as a terrific
deal. But that same modification offered to a borrower who is
12 months delinquent is apt to be regarded as a huge increase
over the then-present (defaulted) payment of ``zero.'' We were
pleased to see changes in the HAMP incentive structure to
encourage earlier modifications.
3. Finally, we found that principal modifications (as opposed to
interest rate or capitalization modifications) have the highest
success rate, even controlling for these 2 first factors.
We at Amherst are not the only market participants who have
discovered that principal modifications have a higher success rate than
other types of modifications. A study \2\ by Moody's Investor Services
looked at modification success by LTV (loan-to-value) bucket (a group
of loans grouped along similar characteristics), and showed that loans
with lower LTVs have higher modification success. Most importantly,
they showed that the difference in modification success between loans
grouped by LTV buckets becomes more pronounced over time. That is, the
difference between LTV buckets is much greater after 18 months than it
is after 6 months from modification. Clearly, principal reduction will
reduce the LTV on the loans, whereas other types of modifications will
not. In further studies at Amherst, we have independently come to the
same conclusion.
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\2\ ``Principal Reduction Helps To Reduce Re-Default Rates in the
Long Run'', Moodys ResiLandscape, Moodys Investor Service, dated 1/20/
2012.
---------------------------------------------------------------------------
We very much like the construction of the principal reduction
alternative under HAMP. It is done as ``earned forgiveness''; the
principal is initially forborne, and \1/3\ is forgiven per year, but
only as the borrower continues to make ontime payments. We believe this
is a very important feature for a principal reduction program.
Moreover, the recent tripling of the HAMP incentives under the
principal reduction alternative, with the incentive going to the owner
of the risk (the lender), should further spur the use of this
alternative. We applaud the Treasury for taking this action.
The moral hazard issue is the single largest mental obstacle many
market participants face when thinking about principal reductions. Will
performing borrowers intentionally go delinquent in order to get a
principal reduction? We have two responses to this. First, the moral
hazard issue is present even under the present program. In fact, while
we believe a successful modification program is essential to restore a
healthy housing market, no modification program can be designed to
completely eliminate moral hazard. Second, you can structure the
principal reduction to minimize the moral hazard issue.
In order to show that moral hazard exists under the present
program, look at Exhibit 3 (next page). We divided the universe of
private label securities between owner-occupied borrowers and nonowner-
occupied borrowers, as only owner-occupied borrowers were eligible for
the HAMP modification program, which started in early 2009. \3\ We have
confined our work to the private label securities universe, as we have
very good payment information about these loans. Exhibit 3 shows the
rate at which performing borrowers are going 2 payments behind for the
first time; this is referred to as the ``default transition rate.''
Note that for borrowers whose loans are considered ``Prime'' and ``Alt-
A,'' the default transition rate between owner-occupied and nonowner-
occupied borrowers diverged significantly around the time the HAMP
program was announced, as borrowers believed it was necessary to be 2
payments behind to receive a modification. BOTTOM LINE--Under the
present program, some borrowers have clearly gone delinquent in order
to qualify for a modification.
---------------------------------------------------------------------------
\3\ On March 9, 2012, under HAMP Supplemental Directive 12-02,
HAMP eligibility was extended to investors. However, this was not a
consideration for the period covered in Exhibit 3.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
It is possible to structure a principal reduction program to
minimize the moral hazard issue (that is, to counter the incentive that
otherwise healthy borrowers have to default on their loan to obtain a
modification). There are several ways to do that. The first is to
require that the borrower already be delinquent at the start of the
program, so borrowers are unable to plan to go delinquent to obtain the
modification. Secondly, a shared appreciation feature can be offered.
If a borrower accepts a principal write-down modification, the lender
is entitled to some share of future appreciation. For the borrower
whose loan is at 120 LTV--a write-down to 110 or 115 percent LTV along
with giving up some percent of the upside will look unattractive. But
for a borrower at 150 LTV, who is far more likely to default, this will
appear very attractive. Senator Menendez, I know shared appreciation is
an idea you have championed.
While we are huge fans of principal reduction, we are concerned
about the moral hazard issue for both the borrower and the servicer. We
have just discussed how it can be mitigated for the borrower. We are
also concerned about the recent Attorneys' General Settlement allowing
servicers to do ``abusive'' modifications in order to get ``credit.''
We applaud the use of principal reductions on loans in a bank/
servicer's own portfolio to meet these credits. But we have a problem
with spending investor dollars to meet a penalty which was the result
of sloppy foreclosure practices on the part of the servicer.
The GSEs and Principal Reduction
We were very pleased to see that under the Obama plan, incentive
payments for principal reduction are now being offered to the GSEs.
Prior to this (as Exhibit 2 has shown), the GSEs (and FHFA as their
regulator) have been reluctant to approve principal forgiveness
modifications, as they believe it is not NPV-positive to their
agencies, and is hence inconsistent with the idea of conservatorship.
FHFA Chairman DeMarco recently responded \4\ to a request from the
House Committee on Oversight and Government Affairs to look at whether
principal forgiveness on GSE loans would serve the interests of the
taxpayer. That letter contained the results of the FHFA study (FHFA
Analysis of Principal Forgiveness Loan Modifications) that compared
losses to the GSEs from principal forgiveness versus principal
forbearance, using the HAMP NPV model. They found that the losses were
very similar.
---------------------------------------------------------------------------
\4\ FHFA letter to the Honorable Elijah E. Cummings, Ranking
Member, Committee on Oversight and Government Reform, January 20, 2012.
---------------------------------------------------------------------------
We have three major criticisms of the methodology used for in the
FHFA study:
First--A hypothetical model (the Treasury NPV Model) was used for
the analysis, and there was no effort to look at actual HAMP results.
Actual results (not hypothetical ones) should clearly be used where the
data are available. If I am testing a new medical drug and have actual
data on effectiveness in humans, I would clearly use that rather than
data on theoretical effectiveness. And in this case, the data are
available. The Principal Reduction Alternative under HAMP went into
effect in October 2010. This suggests that the HAMP program has 16
months of data which can be used to measure the success of the
Principal Reduction Alternative (the forgiveness program) versus the
standard HAMP waterfall (which reduces the interest rate, extends the
term, and forbears principal if necessary). These actual HAMP results
should have been examined.
Second--There were four serious technical issues in the conduct of
the study, which made principal forgiveness less appealing:
A. State level price indices were used, not MSA level indices. Thus,
the FHFA picked up fewer high LTV borrowers than there actually
are. These high LTV borrowers are aided more by principal
forgiveness than their lower LTV counterparts.
B. The results were done on a portfolio level, not an individual
loan level. Thus, the FHFA did not consider the possibility of
following a forgiveness strategy for some borrowers and a
forbearance strategy for others. This would have clearly
dominated the use of a single strategy.
C. The actual HAMP program was not evaluated. The principal
forgiveness in the HAMP program is the lesser of (the current
LTV--the target LTV) or 31 debt-to-income. The FHFA
automatically assumed principal reduction equal to (the current
LTV--the target LTV). Thus, they overstated the amount of
principal reduction that would have been granted for higher
income borrowers. (For these higher income borrowers, the 31
DTI target would have required less forgiveness.)
D. Attributes of the loan at origination, not current attributes,
were used for the analysis. Delinquent borrowers, on average,
have suffered a deterioration in FICO scores. By using
origination characteristics, the health of the borrower is
overstated, hence the assumed likelihood of success is too
high. This overstates the cost of forgiveness.
Third--The FHFA study did not consider any differentiation between
loans with mortgage insurance versus loans without it. If the overall
result for the GSE book of business were very similar for forgiveness
versus forbearance, forgiveness on loans with mortgage insurance should
be more NPV-negative to the GSEs than would be forbearance, and
forgiveness on loans without mortgage insurance should be more NPV-
positive than forbearance.
The mortgage insurance point is critical. Roughly 32 percent of the
GSE portfolio of seriously delinquent loans carries mortgage insurance.
If the GSEs do a principal write-down, they take the loss on loans
irrespective of whether or not they have mortgage insurance. If the
loan with mortgage insurance would otherwise (no modification or a
different type of modification) have defaulted, the mortgage insurer
would have paid the GSEs the coverage amount due. We'll use an example
to make this clearer. Assume a borrower has a $100,000 loan, on a house
worth $75,000. The GSEs have mortgage insurance from a mortgage
insurer, which covers any loss down to $70,000. \5\ Assume that the
borrower defaults, and the GSE offers the borrower $20,000 of principal
reduction, which reduces the loan balance to $80,000, and gives the
loan a 75 percent chance of eventual success. If the loan does not
redefault (there's a 75 percent chance of that happening), the GSE
loses the $20,000 principal amount they gave up. But if the loan
redefaults and the house then sells for $70,000 (25 percent chance),
the mortgage insurance pays $10,000 to the GSE for the lost principal,
in which case the GSE still loses $20,000. If principal is forborne,
and the borrower defaults, the mortgage insurer would cover the loss.
So when there is mortgage insurance, it is generally not NPV-positive
to the GSEs to do principal forgiveness--forbearance creates the
preferred outcome, as the MI does not cover the forgiven amount.
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\5\ In this case, the mortgage insurance covers the first $30,000
in losses. It does not cover additional losses to the holder if the
loan repays $70,000 or less.
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For loans without mortgage insurance, it is generally NPV-positive
to the GSEs to do principal forgiveness. Let's assume the same
defaulting borrower as above. The borrower achieves the same payment
relief under the standard HAMP waterfall and under the principal
reduction alternative, so the NPV of the cash flows will be very
similar (the difference will be the discounted value of the forborne
amount; and remember that the present value of $20,000, 40 years from
now, assuming a 5 percent interest rate, is approximately $2,800).
However, the default rate will be lower on the forgiveness modification
(as it will have a lower postmodification LTV), lowering any further
loss as well as the expenses associated with that loss, thus making it
the more attractive option for the GSEs.
And there is no question in my mind that forgiveness could be
implemented for part of their book of business, without implementing it
on the entire book of business. Precedence for this comes from the HARP
program, where only loans issued before the June 1, 2009, cut-off date
are eligible for a streamlined refinance.
We understand that the primary issue in the mind of the FHFA is
that more than 90 percent of GSE loans are current, and FHFA is very
concerned about the moral hazard issue. The fear is that principal
write-downs encourage borrowers to default who otherwise would have
stayed current. As we point out above, there are two easy solutions to
the moral hazard issue. The first solution is to require that the
borrower be delinquent as of a certain date, so performing borrowers do
not intentionally go delinquent in order to get the principal
reduction. The other choice is to establish a series of frictions so
that only those borrowers who need the principal reduction take
advantage of the program. This could involve the inclusion of a shared
appreciation feature or other frictions to default.
We hope that new measures permitting the GSEs to be eligible for
the principal reduction incentive payments would allow the FHFA to
reevaluate their stance on principal forgiveness. And the newly
announced triple incentive payments will be incorporated in Version 5.0
of the Treasury NPV model. We would urge the FHFA to rerun their
results, using the new model which incorporates the triple incentives,
correcting the technical flaws in their analysis, and breaking out
loans with and without mortgage insurance separately. We believe when
this is done, it will be clear that forgiveness is the better solution
for the bulk of the \2/3\ of their book of business without mortgage
insurance. Moreover, we believe that once the GSEs start doing
principal forgiveness, the program will become even more widespread in
PLS (private label securitizations), as servicers will make the
investment in the technology to make it available for all delinquent
loans.
Demand Side Action--Bulk Sales
I can't tell you how pleased we are to see the announcement of the
Fannie Mae bulk sales pilot program. I testified before the Senate
Committee on Housing, Transportation, and Community Development last
September on the need for bulk sales. The argument in favor of bulk
sales is that there is a huge shadow inventory of homes that needs to
be absorbed. Roughly 2.7 million borrowers have not made a payment on
their home in over a year. Another 400,000 homes are in REO (the ``real
estate owned'' category, which consists of troubled properties that
have been repossessed). Collectively, they constitute a shadow
inventory of 3.1 million units. There isn't insufficient demand from
owner-occupants to absorb this number of units. Thus many of these
properties must transition to investors. Currently, some of the
properties are transitioning to smaller investors, but, prior to this
program, there was no mechanism for institutional investors to buy
properties in bulk.
Buying in bulk is important to an institutional investor, as they
want to put into place a professional property management organization
and a rental organization, both staffed locally. If an institutional
investor has only accumulated a few homes, it is difficult to justify
the cost of building out the necessary service organizations. But if
they are able to accumulate a large number of homes at once, it becomes
economic to do so. It also suggests that institutional investors will
pay a premium to accumulate the properties in bulk than one-by-one. We
believe that both Fannie Mae and FHFA will be very pleased with the
execution of the pilot program, and will choose to implement on a
larger scale, by selling both nonperforming loans and REO properties.
What about the argument that selling homes one-by-one is more
profitable? We believe that will prove to be incorrect. First,
institutional investors will pay a premium to accumulate in bulk.
Second, when you sell homes individually, all the properties sell more
slowly, plus many don't sell at all. Marketing costs are also higher.
Consider the costs of a slower sale: tax and insurance payments still
have to be kept current until the home is sold. Plus, the GSEs are
either paying to maintain the property, or realizing a lower sales
price because the condition of the home is deteriorating.
In the construction of this pilot program, we encourage the
provision of financing. Currently, there is no mechanism for financing
scattered site single home purchases of more than a small number of
properties (Fannie will finance a maximum of 10 properties; Freddie a
maximum of 4 properties). It makes little sense to have a cut-off based
on the number of properties. Rather, very conservative financing should
be provided--and by conservative, we mean at least 30 percent down
payment. The provision of financing would be reflected in higher bids
on the property. Hence, the financing would be a benefit to the
taxpayers, not a cost.
We believe that by giving institutional investors the ability to
purchase homes in bulk, large amounts of shadow inventory can be
absorbed. This will make substantial progress toward cleaning up the
shadow inventory, which is critical to stabilizing home prices. Once
home prices stabilize, the hope is that credit availability will
increase.
Credit Availability Standards
There is currently a disconnect in the housing market between
affordability and the level of housing activity. The National
Association of Realtors Home Affordability Index is at its highest
since they began tracking it in 1986. This Index measures the ability
of the median family to purchase the median priced home, putting down
20 percent and taking out a 30-year fixed rate mortgage at prevailing
interest rates. With the Case Shiller Home Price Index down 34 percent
from the peak, and 30-year fixed rate mortgage rates at the lowest
level they have been since the 1960s, it is not surprising that housing
looks quite affordable. The real question is--Why is the Mortgage
Bankers' Association Index measuring purchase activity at a 15-year
low?--why are existing home sales so low?
The answer is that credit availability is very tight. Affordability
based on median income is at an all-time high but, at the same time,
the median family balance sheet cannot afford to put down 20 percent on
a home purchase, nor can they qualify for a 30-year fixed rate mortgage
at today's qualification standards. (And if a borrower wants to put
down more less than 20 percent on a conventional loan, they will need
either mortgage insurance or a second lien; both have become
increasingly difficult to obtain.) In reaction to the extremely sloppy
underwriting standards prevailing in the 2005 2007 period, the GSEs and
bank originators have dramatically tightened origination standards. The
average GSE origination for 2009 2011 has a 762 FICO, and a 68 LTV. The
average bank portfolio loan has a 756 FICO, 67 LTV. Moreover, almost 20
percent of the 2007 borrowers have defaulted or gone more than 90 days
delinquent on their existing loan, thus ruining their credit score and
making them unable to buy another property.
Yes, lending standards were certainly too loose in the 2005 2007
period, but they are now too tight everywhere, with the exception of
FHA/VA loans. And every single action that is being contemplated will
actually make them tighter. One point of particular concern for us is
the Qualified Mortgage (QM) Standards.
We expect the CFPB (Consumer Finance Protection Bureau) to finalize
an ability-to-repay rule that does not contain a safe harbor from
liability for lenders who make a QM (Qualified Mortgage) loan. Instead,
preliminary discussions indicate the CFPB is most likely to provide
lenders with a rebuttable presumption and establish a ``bright line''
test of what constitutes a QM loan. If a real ``bright line'' test is
drawn, lenders might be comfortable doing QM loans even with a
rebuttable presumption.
However, it will clearly crimp credit availability for all loan
applications that do not clearly meet the ``bright line,'' and any
ambiguity in the ``bright line'' will further crimp the market.
Moreover, the greater the consideration of ``compensating factors''
which makes for more rational lending standards, the less ``bright
line'' the QM test can be. For example, a 43 percent back-end DTI does
not sound like an irrational limit; however a borrower with limited
income and substantial assets with little of those assets in cash, who
is putting down 40 percent, may not be able to take out a QM loan.
From a lender's point of view, the fear is that default is itself
evidence of lack of ability to repay. The penalties for non-QM
compliance are substantial. Moreover, for loans done outside of a safe-
harbor and/or the ``bright line'' test--i.e., non-QM loans--lenders
will be subject to Truth in Lending Act (TILA) litigation risks; it is
reasonable to expect borrowers to commonly allege lack of ability-to-
repay, and to seek TILA damages. Litigation is expensive--on average
costing lenders about $70,000 $100,000 per loan--costs that far exceed
the few thousand dollars that a lender might make on originating any
one loan.
Some predict that there will be a vibrant market for non-QM loans,
but that is not likely because of the liability associated with
originating those loans. Suppose an investor were willing to purchase
MBS backed by non-QM loans. If the non-QM borrower were to allege a
lack of ability-to-repay, the investor could look to the originating
lender for recovery, under the lender's representations and warranties
that the loan met the ability-to-repay requirements. We expect that
investors may be willing to buy MBS backed by non-QM loans originated
by well-capitalized lenders, but those lenders may not be willing to
make non-QM loans because the liability far exceeds the potential
profit from loan origination. Lenders with limited capital may be
willing to make non-QM loans, but those lenders will not be able to
attract investors. There will be no ability to make higher cost loans
to more risky borrowers.
We expect the ability-to-repay rule to further constrain mortgage
credit under any circumstances. However, unless the final rule includes
either a safe harbor and a ``bright line'' test or, at a minimum, a
very clear ``bright line'' test in conjunction with the rebuttable
presumption, the rule will limit the availability of mortgage credit.
Conclusion
In my testimony today, I have discussed three actions that can
strengthen the mortgage market, at no or minimal cost to taxpayers:
increasing reliance on principal reduction modifications; a ramp up of
the bulk sales program, coupled with financing for these properties;
and a careful vetting of new rules that affect already tight credit
availability.
We urge Congress to do everything they can to facilitate these
actions.