[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

                              ----------                              

                        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
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
     \1\ Denk, Dietz, and Crowe, ``Pent-up Housing Demand: The 
Household Formations That Didn't Happen--Yet'', National Association of 
Home Builders. February 2011.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
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