mortgage recovery backstop: the path to a functional market
TRANSCRIPT
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June, 2009 Mortgage Recovery Backstop: The Path to a Functional Market for Legacy Non-Agency Mortgages and Mortgage-Backed Securities
David Snyderman, Michael Henriques and David Wecker
This White Paper examines the market for mortgage assets in the context of the current credit crisis. It analyzes the microstructure of the market for legacy non-Agency mortgage assets, identifies the key factors that determine prices and evaluates the effectiveness of current and potential policy solutions.
It argues that a mortgage recovery backstop, which would act like mortgage insurance to guarantee a minimum recovery to lenders in cases of foreclosure, could play a key role in restoring a functional market for legacy non-Agency mortgages and mortgage-backed securities.
It further demonstrates how a mortgage recovery backstop could be implemented as part of the Obama Administration’s Home Affordable Modification Plan (“HAMP”) – ensuring the program’s success by aligning the interests of lenders, servicers and borrowers to efficiently repair the mortgage market, and achieving the public policy goal of keeping more people in their homes and avoiding a foreclosure crisis.
The Paper illustrates how a modification program that contains a mortgage recovery backstop would be relatively inexpensive to taxpayers in its implementation, would be executable with limited complexity and would sunset naturally.
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ABOUT MAGNETAR CAPITAL
Founded in 2005, Magnetar Capital is a leading alternative asset manager. Headquartered in Evanston, Illinois, Magnetar has satellite and affiliate offices in New York, Philadelphia, London and Beijing. Magnetar is a global, multi-strategy investment manager that seeks to achieve stable risk-adjusted returns by employing a wide range of equity- and credit-driven strategies, investing across the capital structure, and investing in both public and private transactions. Magnetar employs both fundamental and quantitative driven strategies.
ABOUT THE AUTHORS
David Snyderman has 16 years of experience in fixed income and structured credit products. Mr. Snyderman is a Senior Principal at Magnetar Capital and is currently Head of Fixed Income. Previously, Mr. Snyderman was Global Head of Credit at Citadel Investment Group. Mr. Snyderman began his career at Koch Industries and holds a B.S. from Washington University.
Michael Henriques is a Principal at Magnetar Capital and joined Magnetar after 15 years at Goldman Sachs and Deutsche Bank in a variety of real estate and structured credit positions. While at Goldman in the early 1990’s, Mr. Henriques wrote valuation models for non-performing residential mortgage loans and worked closely with servicers in developing their collection strategies on the firm’s principal investments. Mr. Henriques later structured and traded RMBS and whole loan residential mortgage pools. Mr. Henriques holds an A.B. from Princeton University and a M.B.A. from Wharton.
David Wecker is a Principal at Magnetar Capital and has 8 years of experience researching Government policy for event driven and fixed income strategies. Previously, Mr. Wecker was a portfolio manager at Citadel Investment Group. Mr. Wecker holds an A.B. and an M.A. from Princeton University, where he was a Mellon Graduate Prize Fellow in the Center for Human Values, and a M.T.S. from Harvard University.
Contact Information: David Wecker
(847) 905-4750
Magnetar Capital LLC 1603 Orrington Avenue Evanston, Illinois 60201 847.905.4400
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TABLE OF CONTENTS
INTRODUCTION AND BACKGROUND .............................................................................................................4
SUMMARY ......................................................................................................................................................5
THE MICROSTRUCTURE OF THE MARKET FOR NON-AGENCY MORTGAGE ASSETS ......................................7
MORTGAGE RECOVERY BACKSTOP ..............................................................................................................15
REAL MONEY FOR DISTRESSED ASSETS ........................................................................................................22
MAKING MODIFICATIONS WORK .................................................................................................................26
CONCLUSION ................................................................................................................................................30
APPENDIX .....................................................................................................................................................31
DISCLAIMER
The information contained in this White Paper represents the current view of Magnetar Capital LLC (“Magnetar”) on the issues discussed as of the date of publication. Because Magnetar must respond to changing market conditions, it should not be interpreted to be a commitment on the part of Magnetar, and Magnetar cannot guarantee the accuracy of any information presented after the date of publication. This White Paper is for informational purposes only and is not intended to, and does not, offer any product or service to the reader of this White Paper. MAGNETAR MAKES NO WARRANTIES, EXPRESS, IMPLIED OR STATUTORY, AS TO THE INFORMATION IN THIS WHITE PAPER. Copyright 2009, Magnetar Capital
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INTRODUCTION AND BACKGROUND
The current credit crisis and deep economic recession have made restoring the health of the credit markets a key policy goal for the United States Government. The mortgage market is at the epicenter of this crisis for a number of reasons:
It is the largest of the nation’s credit markets.
Of all asset classes, housing is the largest contributor to the wealth and well being of Americans.
The recent housing bubble and price collapse sparked the current wider financial crisis and economic recession.
The mortgage crisis has crippled the banking system and other systemically important institutions such as the GSE’s and AIG.
The collapse of mortgage asset values has frozen the market for legacy securities, which need to be sold by banks to free up capital and allow for recapitalizations where needed.
A foreclosure crisis threatens a further spiraling downward of home prices and can destroy the very fabric of local communities.
As a result, policies should be adopted which can effectively address the current mortgage crisis in the most efficient and expeditious way possible. A return to a well-functioning market for legacy mortgages and mortgage-backed securities will help to cleanse the financial system of so-called “toxic assets” that are imperiling the solvency of our financial institutions, will unclog the market for new credit desperately needed to grow the economy, and, in conjunction with other policies, will address the foreclosure crisis in an effective way.
There is no silver bullet for the host of problems caused by the collapse of mortgage asset values. Indeed, the Government is pursuing multiple policy solutions. To date, Government programs have focused on two objectives: avoiding defaults and providing leverage to potential buyers of mortgage assets. Government policy has not yet effectively addressed the risk to lenders from severity upon default (the percentage of the face value of a loan an investor recovers through the sale of a foreclosed property). Below, we argue that a policy response to the risk of severity upon default is needed to align current Government programs and restore health and confidence to the mortgage market.
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SUMMARY
We believe an analysis of the mortgage market and potential policy responses to the current crisis leads to the conclusion that the Government should augment its current modification program with a “mortgage recovery backstop”, or guarantee, for 75% of the newly underwritten home value for mortgages that are modified through Treasury’s Home Affordable Modification Plan (“HAMP”).
Adherence to certain guiding principles has led us to this conclusion, and we have organized the Paper around these principles in the following four sections.
Section 1 -- “The Microstructure of the Market for Non-Agency Mortgage Assets” is animated by the principle that:
The success of a program designed to stabilize and increase the value of depressed assets needs to target the key risk factors by individual asset class. Risk factors are best understood by analyzing the market microstructure through which prices for these assets are set. This section analyzes the specific constraints confronting mortgage assets in distinction to assets backed by prime credit cards, prime auto loans, and student loans. We develop the analytical construct of “transfer of balance sheet” vs. “transfer of risk”, from which vantage point we can evaluate where and to what extent leverage and a lower cost of capital can solve an asset pricing problem. We argue that where credit risk is the main factor, leverage is not effective in stabilizing value. A Government or Agency guarantee of recovery at 75% of the newly underwritten home value for modified loans substantially reduces the severity of the worst-case outcomes for lenders, allowing distressed mortgage assets to trade at prices that more closely reflect base case scenarios.
Section 2 - “Mortgage Recovery Backstop” describes the proposal in detail and argues that:
In addressing the mortgage crisis, Government should give priority to policies that minimize cost and complexity, utilize existing infrastructure, are short-lived, have the least long-term negative or unintended consequences and have a clear and easy exit strategy. Government is intervening in the financial markets to an unprecedented degree. Policy choices made today will have significant consequences on the mortgage market for generations to come. Government intervention that is perceived to be harmful to lenders will have grave implications on the future risk premiums lenders and investors will demand, thus making homeownership more expensive for millions of future homebuyers. Furthermore, policies that can be easily implemented, particularly with the least amount of Government entanglement with the private sector, should take priority over those policies that are difficult to implement and create more uncertainty as to market structure and institutional delineation and mission. As a result, policies that are less complex and have a clear exit strategy for the Government should be privileged.
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Section 3 – “Real Money for Distressed Assets” is based on the idea that:
Any solution to an asset value problem should seek to expand the number and quality of participants. Policies that encourage broad market participation are far more likely to achieve and sustain their goals than solutions based on fewer market participants, especially where those market participants have access to smaller and more expensive pools of capital. The section demonstrates that a mortgage recovery backstop can re-open the market for legacy non-Agency mortgage assets to traditional “real money” investors, including mutual funds with investment grade mandates, insurance companies and foreign sources of capital. Ratings downgrades in particular have circumscribed the pool of potential buyers to a small number of lightly capitalized players compared to the large universe of well capitalized investors which originally could and did fund the non-Agency market.
Section 4 – “Making Modifications Work” has at its core the principle that:
The success of policy is dependent upon the extent to which market participants are brought into proper alignment. Alignment needs to be addressed within two spheres: between lenders, borrowers, servicers and the Government; and between or among Government programs. The implementation of the administration’s current modification program risks favoring the interests of servicers and borrowers over lenders. To the extent such misalignment further harms the prices of mortgage assets, the modification program will be misaligned with both the Government’s programs to provide support for mortgage asset values through TALF 2 and PPIP and the Government’s programs to provide capital support to the nation’s financial institutions.
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THE MICROSTRUCTURE OF THE MARKET FOR NON-AGENCY MORTGAGE ASSETS
Traditional Valuation Risks in Mortgage Securities
Historically, mortgage asset valuations primarily reflected market assumptions regarding interest rates and pre-payments. Against a background of 40 years of rising home prices and low defaults, projections regarding the credit risk of mortgages were less important factors in determining market clearing prices. Credit risk for a pool of mortgages consists of default frequency1 and severity2 or recovery upon default.
Current Valuation Risks: Severity and Tail Risk
Current market pricing for legacy non-Agency mortgages and mortgage backed securities incorporates significant risk aversion to tail scenarios (worst case outcomes). In the current mortgage crisis, where defaults in certain pools of non-Agency mortgages already approach 50% and are projected to go much higher, market pricing is largely a function of market assumptions regarding credit risks.
The following graph shows the impact on returns to an investor in a senior RMBS security of varying cumulative levels of mortgage defaults under three different scenarios for severity assumptions (keeping the rate of defaults as a constant). In a base case scenario for the illustrated pool of Alt-A loans, an investor may project a 16% annual return on an investment. The base case assumes that 70% of the loans within a mortgage pool will suffer default over time (meaning 70% of the borrowers in the loan pool stop paying, the loans to those borrowers are foreclosed, and the real estate is subsequently sold). The base case also assumes that the lender will realize 35% net recovery proceeds upon liquidation (the sale of foreclosed real estate) for every dollar balance of loans which defaults. 35% recovery equates to 65% severity.
To put these numbers in the context of current market conditions, many Alt-A quality mortgage pools currently have more than 40% of borrowers delinquent. Recoveries on these pools from loans that have been liquidated have decreased from about 60% to below 50% over the last several months (i.e. severities have increased from 40% to over 50%). Therefore, the base case scenario appears somewhat conservative relative to the current performance of the assets, but is not inconsistent with the poor recent performance trajectory. However, if recoveries are just 10% lower and defaults are 10% higher, the yield to an investor drops from 16% to about 7%.
1 If 100 loans out of a pool of 1000 loans default, meaning the borrower permanently stops making payments of principal and
interest, the default frequency is 10%. The timing of defaults can be a significant variable in the value of certain mortgage backed securities, particularly those backed by deeply distressed pools of mortgages. We don’t discuss the timing of defaults as a separate risk factor in this Paper because it is far less important to the securities market as a whole than default frequency and severity. 2 “Severity”, which is a measure of loss in a loan or pool of loans, is the percentage defined as 100% less the net recovery
percentage. Net recovery is usually quoted as a percentage and is the amount lenders receive from the sale of foreclosed real estate after liquidation related expenses. With respect to RMBS, foreclosure and property maintenance expenses, as well as advanced delinquent payments, are also reimbursed to the servicer from the liquidation proceeds and are thus incorporated into the recovery percentage. For example, a home with a $100,000 mortgage that is sold in foreclosure for $70,000 net proceeds has a 70% recovery and 30% severity.
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Typical 2006 Alt-A Security – 40%+ Delinquent
This graph shows that as projected liquidations increase, the value of the security becomes very sensitive to severities. Market pricing is extremely risk averse because of uncertainty regarding tail scenarios.
The valuation of credit securities is very data-intensive. Without good historical data it is very difficult to price assets correctly. All of the accumulated historical data for non-Agency mortgages is no longer very useful as the old data is obsolete and the recent data is likely to be too extreme. Over the long term, the United States is likely to be one of the world’s best housing markets due to growth in population and household formation. Indeed, it was because historical housing trends were so robust and long term trends appeared very positive that excesses appeared at all levels of the marketplace. 3 Because market participants can no longer rely on historical credit data for mortgages, prospective buyers and sellers of mortgage securities cannot agree on credit risk, and so they price these assets very differently.
Buyer Perspective
Buyers are demanding high yielding returns in base case scenarios because they are unwilling to take risk of losing significant capital in conceivable tail scenarios. This is not irrational. The performance of pools such as the one illustrated above has been dismal – losses have far exceeded any historic base case. Therefore, investor decisions whether or not to purchase must reflect not just the expected yields, but also a desire to survive if outcomes turn out to be worse than expected. To the extent the worst case outcome is too severe, the investor will not purchase such a security. In addition, recent Government proposals, including mortgage cram-down legislation and the HAMP modification program, have led investors to price in a significant amount of political risk to recoveries. In short, buyers perceive significant risk of actually experiencing the tail scenarios and they price assets accordingly.
3 Bubbles, other than of the tulip variety, usually form because there is good reason to expect strong fundamentals– e.g., the
internet equity bubble was only possible because investors rightly perceived the importance of the internet.
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Seller Perspective
Sellers, on the other hand, who mostly rely on bank reserve and GAAP valuations which incorporate base case and best case estimates, are only willing to offer their assets for sale at prices reflecting the “expected” outcome, effectively implying a fair degree of certainty around base case outcomes with no material risk aversion premium. The fundamental difference in buyer’s and seller’s perspectives creates a valuation gap, illustrated below.
The Valuation Gap in Mortgage Securities
The large gap between depressed market prices for non-Agency mortgage assets and the prices at which sellers are willing to sell is primarily a result of market participants having varying assumptions regarding credit risk. This uncertainty has led to a stalemate between banks and outside capital providers, preventing the removal of toxic assets from the balance sheets of banks.
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Smaller Valuation Gaps Exist for Other Credit Assets
By contrast, there are areas within consumer credit where buyers and sellers do not have widely divergent assumptions regarding risk. The markets for assets backed by prime credit cards, prime auto loans and FFELP student loans have also suffered significant dislocations, but largely for a different reason. The current performance of these assets has more closely tracked their expected performance based on historical experience and correlation to well understood economic factors such as the unemployment rate. Consequently, buyers and sellers have much less disagreement on the amount of credit risk in any given pool of these consumer assets and, accordingly, the aggregate expected cash flows from pools of such assets.
Where the market perceives cash flows are certain, buyers are willing to transact at prices where the return of the investment matches up with their required return on capital.
The Effects of De-Leveraging on Securities Prices
Buyers have lost access to their traditional sources of leverage in the current credit crisis. In a functional credit market, investors can lever returns on assets (ROA) up to their required return on capital or equity (ROE). The least risky assets, consequently, would trade at a very low ROA and investors would lever their investment up to their required rate of return, or ROE. In the current environment, leverage has either been unavailable or the cost has become considerably more expensive than in the past. As a result, the ROA’s across the capital structure have shifted to approximate unlevered or equity returns.
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The following chart shows the traditional relationship between the riskiness of an asset, the ROA demanded by the market, the leverage a buyer can get to finance the purchase of an asset, and the ROE that can then be achieved. In the pre-crisis world, the more senior (i.e., less risky) the asset (senior tranches have first claim on cash flows in a securitization, the other tranches are structurally subordinated to the senior tranche4), the lower the ROA, the more leverage could be obtained from a third-party lender. A buyer with an equity-like return hurdle of Libor + 12.5% could achieve the same ROE by buying different tranches of a securitization with varying amounts of leverage.
The unlevered ROA for the senior tranche would be very low, here a spread of 50 basis points to Libor, for two reasons: the assets were rated AAA and accordingly viewed as riskless, and there was third party financing available to lever up these assets to a required ROE. With respect to the riskier mezzanine assets, third party lenders provided less leverage, or fewer turns of leverage, and so these assets would trade at a higher unlevered ROA in order to achieve a comparable leveraged ROE to the senior assets. The equity of the security, or most risky piece, could not be levered economically and thus the ROA for this piece was equal to the ROE required by investors.
When leverage is no longer available, or no longer available at an economic cost, the tranches that most rely on leverage to achieve a required market-required ROE suffer the most price dislocation.
Transfer of Balance Sheet vs. Risk
4 “Structural subordination” can be quoted as a percentage. If the top 50% of a securitization is senior, then the senior
tranche is referred to as having 50% subordination.
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When market prices of assets are most sensitive to cost of capital, market transactions can be understood as transfers of balance sheet rather than as transfers of risk. In these circumstances, where buyers and sellers generally agree on the expected loss of the underlying loans, leverage allows a transfer of balance sheet (as opposed to a transfer of risk) at competitive market rates. For this reason we think that TALF 1, which provides low cost leverage for prime credit cards, prime auto loans and FFELP student loans, will be a successful program, achieving the goal of enhancing available credit for its targeted lending sectors at reasonable rates. The following diagram shows how TALF works to allow buyers and sellers, or in this case issuers, to transact at prices that meet the required return on capital for the investor and achieve an economic cost of capital for the issuer or seller.
In this example, cash flows that both buyer and seller agree are certain trade in the market at a 10%, or equity-like, yield without access to leverage. A Government program to provide leverage at levels closer to historical spreads allows the pool to be transferred from an issuer’s balance sheet to a buyer’s balance sheet at a low blended cost of capital to the issuer and an equity-like return on capital for the buyer. The blended yield including the TALF leverage is approximately 4%, a substantial reduction from the otherwise unlevered required market yield, thus increasing market prices.
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Increased Leverage Will Not Bridge a Valuation Gap Caused by Credit Risk
In contrast, where an actual transfer of risk needs to take place, leverage is not likely to bridge the pricing gap between buyers and sellers. The following diagram illustrates why TALF, or any program that provides inexpensive leverage, is unlikely to work when buyers and sellers have a large disagreement regarding risk.
The following chart illustrates what has happened to the actual prices of securities in response to the
announcement of PPIP and TALF 2 (price shortly before and after the announcement), programs that
rely on leverage to increase mortgage asset values.
While some prices have recently improved, RMBS prices remain generally well below levels from 8 months ago. Where the credit risk factor predominates, asset values have barely changed from their lowest points.
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Summary
We believe our analysis demonstrates that the provision of inexpensive leverage is most appropriate when addressing problems associated with transfers of balance sheet and is neither very effective nor efficient when used to address problems associated primarily with transfers of risk. Consequently, we believe that Government programs will be successful to the extent that they can directly and efficiently address the risk factors of default frequency and severity upon default.
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MORTGAGE RECOVERY BACKSTOP
To address the tail recovery scenarios that are setting the prices for non-Agency mortgage assets in the current market, the Government could expand its current version of a mortgage recovery backstop program to cover 75% of the newly underwritten home value for all qualifying modified mortgages5. In this section we provide a synopsis of the proposal, illustrate how it would affect the value of loans and securities, describe how it fits in with and is derived from the current structure of the HAMP program by replacing the current Home Price Decline Protection (“HPDP) program, discuss the program’s many benefits and efficiencies from the perspective of policymakers and taxpayers and highlight its sunset provisions.
Synopsis of the Mortgage Recovery Backstop Program
Program
Government sponsored guarantee program of minimum recovery in the event of default for covered mortgages
Summary Benefits and Eligibility
Government guarantee of a minimum recovery of 75% of newly underwritten home values for loans modified under HAMP
Lender Fee
10 basis points per year on the 75% LTV amount, paid by investors to the Agency providing the guarantee
Implementation and Monitoring
Servicers would obtain a valuation consistent in quality and method with a newly originated loan6 and GSE’s could use their current infrastructure to track each new loan guarantee over time
Program Lifetime
Naturally sunsets over time as home prices appreciate and insurance no longer provides value
A 10 basis points lender fee and a 75% LTV guarantee or recovery backstop are our best estimates of optimal levels for each. Clearly a range of values could be considered. Before discussing how our proposal fits in with and is derived from current policy, we briefly describe why these particular values are justifiable.
5 As part of maximizing HAMP’s effectiveness, particularly with regard to the health of bank balance sheets, we believe the
HAMP program’s loan limit of $729,750 should be lifted or increased. 6 A full appraisal with access to the interior of the house is preferable to a broker price opinion (BPO), which is based upon an
exterior review and comparable listings and sales.
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Reasons for the Lender Fee to be 10 Basis Points
Private Mortgage insurance is considerably more expensive, typically in the 50-70 basis points range. But private mortgage insurance was for profit and was a negatively selected instrument. Borrowers who could take out quick second lien loans did, and those that could not get second liens purchased mortgage insurance instead. The high price reflected the riskiness of the insurance. By contrast, our proposal is for a guarantee that looks much more like a traditional GSE guarantee, for which Fannie Mae and Freddie Mac have typically charged mid to high-teens basis points. It is justifiable to charge less for the mortgage recovery backstop we propose for a number of reasons: 75% LTV is less risky than the typical 80% LTV that the GSE’s have historically guaranteed; home values are being underwritten well below the top of the housing cycle, greatly reducing recovery risk; modifications under HAMP establish the borrower’s ability to pay, reduce interest rates to as low as 2% and have significant protections against fraud, all of which should further reduce the riskiness of the loans.
Reasons for the Guarantee to be 75% LTV
The proposed backstop would guarantee 75% net recovery of the newly underwritten home valuation for loans that have been modified under HAMP. We view 75% LTV as an appropriate level for a number of reasons: it is less than the standard 80% LTV limit for conforming loans which are implicitly guaranteed by the Government through the GSE’s; it is substantial enough to ensure that most super senior tranches in securitizations will be rated AAA; it will align the interests of the Government with investors to insure high quality underwriting standards in the modification program; it represents the tail risk of the original home loan, as illustrated below.
Mortgage Recovery Backstop for a Typical Loan
Note that our mortgage recovery backstop proposal is for a 75% guarantee of the newly underwritten home value, not its original value. Given home price depreciation in the US of nearly 35%, a typical guarantee will be slightly below 50% of the original home value. The following graph illustrates how a typical $400,000 mortgage (80% LTV or loan-to-value) on a $500,000 house, now valued at $325,000 after suffering a 35% decline in value, would be eligible for a $244,000 recovery backstop under the program.
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Set at 75% of the newly underwritten home valuation, the mortgage recovery backstop provides investors a guarantee against only severe home price depreciation from already depressed current valuations. In this example, the Government or Agency would guarantee only 49% of the original home valuation, greatly minimizing risk to taxpayers.
How a Mortgage Recovery Backstop Would Affect the Value of Legacy Securities
Without the benefit of the mortgage recovery backstop, we believe that almost all originally rated AAA securities will suffer some degree of principal loss. Although structural subordination within the securitization7 varies with the credit quality of the underlying mortgages, the amount of subordination is looking increasingly inadequate relative to the expected losses for all residential mortgage securitizations issued since 2005. Considering the extremes of mortgage credit quality, a typical 2006 sub-prime initially AAA rated security may have 30-40% subordination, but will also have more than 50% of the pool in default. Meanwhile, a prime quality securitization may offer about 5% subordination to the AAA classes while experiencing 8-15% in default. Even though the prime pool clearly has performed better than the sub-prime pool, the senior securities in both cases will (likely) ultimately suffer losses, as losses from the defaulted loans eventually exhaust the subordination.
The extent to which our guarantee program will eliminate or reduce the likelihood of losses is a function of (a) what portion of the underlying loans are modified and accordingly receive the benefit of this guarantee and (b) where the guarantee is “struck” relative to current balances (which is a function of the severity of property value declines). In the case of prime mortgage pools, the large majority of borrowers are performing, thus implying that they may not require modifications and also that they are more likely to still have equity in their homes (thus their positive performance).
7 Please see page 11 and footnote 4 for an illustration of a securitization and a definition of “structural subordination”.
0
100,000
200,000
300,000
400,000
500,000
Original Purchase Price
Original Mortgage - 80%
LTV
New Home Valuation - 35%
Decline
Mortgage Recovery
Backstop - 75% of New Home
Valuation
$500,000 $400,000 $325,000 $244,000
51% discount to original homevaluation
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Although there are very large variations between mortgage securitization pools, it is usually a relatively small portion of prime pools that are in the hardest hit housing markets (say <25%). As many of these prime borrowers are performing well, we may assume that half of these at-risk borrowers, or 12.5% of the total pool, require a modification with the recovery backstop. The backstop will likely guarantee a substantial portion of the current principal balance. For example, if a loan was initially 75% LTV and property values have declined 30%, a recovery backstop at 75% of the updated value would guarantee a minimum recovery of 70% of the current loan balance.8 Rating agencies can then analyze the pool assuming that even if all of these at-risk borrowers ultimately defaulted, losses to the security holders will be about 4% of the total pool balance (calculated based upon the 70% recovery on 12.5% of the pool). In this case, subordinate bondholders will still be substantially wiped out, but the senior securities will recover their principal and should retain their current ratings.
The analysis arrives at a similar conclusion for lower quality mortgage pools, but many more modifications will be required in each pool to achieve the same result. Sub-prime mortgage and option arm pools often have a far higher portion of their collateral mortgages in distressed housing markets, perhaps as high as 75% of the total. However, the most senior securities have approximately 40% subordination. Analogous to the example above, but with more stressed assumptions, consider a loan which was originally 90% LTV in a housing market that has declined 40% in value. The post-value decline LTV is 150%, so the recovery backstop at 75% of the updated value means that the guarantee would be struck at 50% of the current loan balance. If we further assume that 80% of the high risk loans merit modification, then the backstop assures that for about 60% of the total pool, aggregate recoveries will be floored at 30% (and inversely, maximum losses from those loans will be 30% of the total pool balance). The remaining 40% of the pool will be divided between loans which will naturally perform without any modifications and loans which will ultimately be foreclosed and liquidated. Given the 40% subordination levels, subordinate classes will still be largely written off but the senior securities will substantially survive.
In both cases, the recovery backstop should stabilize ratings by providing a guarantee on a significant, although not the entire, portion of the principal balance of the most senior securities. The market will also quickly perceive that the portion of cash flow that is “certain” has materially increased. This will improve pricing for at least three reasons. First, a lower discount rate will be attributed to the certain portion of the cash flows and the market will adjust the all-in pricing accordingly. Second, lenders (both private lenders and also potentially government programs such as TALF) will be comfortable lending against those certain cash flows, thus further reducing the required cost of capital to acquire the securities and increasing prices. Lastly, and perhaps most significantly, the improved ratings stability will reduce the forced selling that has caused market shocks following downgrades as banks and insurers were required to increase capital holdings and funds with ratings-driven investment mandates will be able to make new investments in these securities. We discuss these phenomena in more detail in Section 3 of this Paper.
8 To apply this example to a hypothetical loan, a house with an original value of $1,000,000 has a mortgage for $750,000.
After a 30% home value decline, the current home value is $700,000. If the loan is modified, there would be a guarantee for 75% of the current value. $525,000 is guaranteed, which is 70% of the original loan amount of $750,000.
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Current Government Policy: Replacing HPDP with a Mortgage Recovery Backstop
A mortgage recovery backstop fits naturally into current policies. The following chart shows how current Government programs address the major risk factors in the mortgage market.9
HAMP addresses default frequency through modifications but only contains a modest $10 billion program to address severity upon default. The Home Price Decline Protection (“HPDP”)10 incentive plan (“incentive” because the Treasury recognizes that lenders should be compensated for accepting the risk that modified loans will be worth less than liquidated property)11 provides payments for up to two years to compensate investors for continued home price declines in localized areas post-modification. The payments, capped at $10 billion, are made at the end of each year and are tied to the number of continuing successful modifications.
9 We discuss the government’s modification strategy in greater detail in the last section of this Paper, where we focus on the
alignment of servicers, borrowers and investors. 10
The May 14, 2009 announcement from Secretaries Geithner and Donovan offers the fullest description of the program to
date. Please see the Appendix for actual the actual language of the program. 11
There is a tremendous amount of uncertainty in the market regarding whether the implementation of HAMP will harm the value of affected mortgage assets. Investors’ primary concern is that the traditional contractual alignment between servicers and investors will be severed in order to achieve public policy goals and to benefit borrowers. It is not lost on market participants that the politicization of the mortgage market is likely to favor borrowers. Consequently, mortgage asset prices reflect the possibility that government policy may transfer significant value from lenders to servicers and borrowers. While the government seems to acknowledge these fears, HPDP does not adequately address the concerns of market participants. We take up this topic in more detail in the last section of the Paper.
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While details remain sparse, our estimate is that the effect of HPDP on the pricing of mortgage assets will not be material. The program is undercapitalized relative to the size of the market, does not address the tail risk of low recoveries in re-default and in any case will not change the ratings of the securitizations in which these mortgages reside. Also, HPDP payments, as currently structured, would be made for only two years, and are forfeited in the case where a borrower re-defaults within the first or second year.12 As a result, HPDP does not protect investors against tail outcomes, which are precisely the outcomes which are making the current market dysfunctional.
Our mortgage recovery backstop proposal would replace HPDP, strengthening the HAMP program, but otherwise leaves all the other mechanics of HAMP unchanged. In the next section we focus on effectiveness, implementation and execution from the perspective of policymakers.
Advantages of a Mortgage Recovery Backstop
Our proposal takes the HAMP program of home price decline protection and replaces it with a mortgage recovery backstop, which will strengthen HAMP by providing more incentives to investors to modify loans and will provide a comprehensive solution for the mortgage asset pricing problem. We further improve upon HPDP by proposing that lenders pay a fee of 10 basis points per year on the guaranteed loan amount. Currently, HAMP provides $10 billion of home price decline protection at no charge. The benefits to the market, the economy, and hence to homeowners and taxpayers, from our proposal greatly exceed any potential cost of expanding HPDP into a comprehensive guarantee program. The benefits are many and the direct costs to the taxpayer are likely to be few:
Immediate Impact: By addressing the key risk factor in the non-Agency mortgage market, the program would have a significant and immediate impact on prices.
Limited Cost to Taxpayers:
o Only the Most Certain Cash Flows Are Guaranteed: By guaranteeing only 75% of the newly underwritten home value, there should be little to no loss to the taxpayers. For example, illustrated above, a typical home that is re-underwritten following a 35% home price decline would have a guaranty at 49% of the original home value. If the loan performs, or of it is ultimately liquidated for more than 49% of the original value, then there would be no payments made under the guarantee program, and the premium paid for the guarantee would represent a revenue benefit for the Government or sponsoring entity.
o Funded by Lender Fees: The GSE’s or another Government Agency could charge investors
a premium of 10 basis points a year for the guarantee. This would produce considerable revenue and would further ensure little to no loss for taxpayers. Because of the significant benefits to asset values, bank balance sheets, the credit markets and the economy, the overall net present value of the plan should be significantly positive for the treasury.
12
Payments accrue monthly but are paid out at the end of year one and year two of the two year program. Loans that re-default during either year result in the forfeiture of the accrued, but unpaid, amounts.
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o Unlike HPDP, No Government Payments Until Actual Losses Are Experienced: HPDP compensates investors for indexed home price depreciation for modified loans that have not re-defaulted within a two year period. While we agree with the need to incentivize investors to modify loans, we think Government support should be focused where it will be most effective. Our proposal only compensates investors for actual losses. If loan modifications are successful and re-defaults are few, our proposal will be less expensive for the Government than HAMP with HPDP, as up to $10 billion may be paid to investors for loans that perform.
o Fees Incentivize Early Exit from the Program: Like conventional mortgage insurance,
investors will be incentivized to stop paying for the guarantee when LTV’s improve over time.
Government Oversight and Control: Backstop eligibility would be limited to loans re-underwritten through the Government’s approved modification program, providing additional protection for the taxpayer.
Simple to Administer: The program could be implemented by the GSE’s, using existing infrastructure and expertise. Minimal additional infrastructure would be required as the Government already tracks modifications
Sunsets Naturally: The program will run-off over time as servicers, on behalf of investors, opt out of the program as LTV’s decrease through home price appreciation going forward, and through pre-payments (primarily home sales) and foreclosures. Consequently, there is an easy and built-in exit strategy for the Government and/or Government sponsored enterprises. The program will be at its largest when modifications peak and will shrink as time goes by. Furthermore, it will not require a political process for the Government to achieve its exit.
Ease of implementation, execution and exit are significant advantages of this plan. These advantages stem from the plan’s fundamental simplicity. In the next section, we further develop the theme of the plan’s simplicity, demonstrating how a mortgage recovery backstop will bring more capital into the market for legacy mortgage assets without the need for complex programs that unnecessarily entangle the Government with private enterprise.
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REAL MONEY FOR DISTRESSED ASSETS
This section describes how the investor base for assets varies through the business cycle, the flight of traditional “real money” investors from mortgage assets, the critical role to be played by their return to the mortgage market and how a mortgage recovery backstop can effectuate their return.
The Traditional (“Real Money”) Mortgage Investor
These types of buyers are sometimes referred to as “real money” in Wall Street parlance. The distinguishing feature of “real money” accounts is that they are very large and employ low leverage, if any. They tend to allocate capital for the long term, and their mandates often require them to invest most of their capital in their mandate and not sit on large amounts of cash. Mutual funds qualify as examples, typical hedge funds do not.13 Any securities market that has real money investors will tend to be significantly more liquid and more stable than a market that does not have this class of investors as potential buyers.
Distressed Markets Cause Real Money Investors to Flee
The current mortgage crisis dwarfs any other recent distressed market in both size and scope. As in other examples of distressed markets, the number and quality of potential buyers has been greatly diminished. The global pools of money with a mandate to buy investment grade credit, or even AAA credit, is many orders of magnitude larger than the pools that have mandates to buy sub-investment grade debt. Although banks and insurance companies are not prohibited from owning low rated credits, the risk weightings of these assets result in highly inefficient capital requirements for these financial institutions, effectively prohibiting ownership.14 When a market as large as the non-Agency mortgage securities market faces wholesale ratings downgrades, it is the case there is not enough capital to provide bids that would support the prices of these assets. Also, even though a portion of the mortgage loans within a given securitization trust may be very high quality, the entire pool will trade at distressed prices reflecting the downgraded ratings of the bonds.
13
Hedge fund managers typically can choose to not invest in an asset class if they believe the returns are not attractive, or they can otherwise hedge their investments so as to isolate their exposure to a particular risk factor without having to be exposed to all the risk factors of an asset. Additionally, hedge funds often invest in strategies where traditional investors cannot invest. The shorting of stocks is a well known example. Indeed, the absence of competition from traditional investors has traditionally made these strategies profitable. Distressed investing is another such strategy. In the corporate space, the vast majority of money allocated to equities or bonds does not have the mandate to buy the fulcrum security of a company going through Chapter 11 (the “fulcrum” is the part of the capital structure that will most benefit from a recovery in value). However, there are times when a trade claim for example, is the best value in the market for a given company in a restructuring. But most funds are restricted from purchasing such claims either because of pre-specified mandate limitations or because realization of value requires active management and expenditures. Were there to be a dramatic and sudden increase in the supply of such securities, as has happened in the mortgage asset space, we would see tremendous market dislocation and prices of assets would not recover until more funds were dedicated to the space or until the subject companies exited Chapter 11. 14
See International Convergence of Capital Measurement and Capital Standards: A Revised Framework, Basel Committee on Banking Supervision, Bank for International Settlements. June, 2004.
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Programs that Provide Leverage Do Not Return Traditional Investors to the Legacy Non-Agency Market
Government policy is addressing the issue of scarcity of buyers through TALF 2 and PPIP by making available large amounts of below market leverage to investors who have a mandate to buy non-Agency mortgage assets. As we argue above, there is reason to doubt that these programs will be effective in closing the pricing gap between buyers and sellers in the market. Policies that directly address risk factors will be more successful.
Increasing buying power by subsidizing leverage will increase only marginally the amount of private equity capital in the market for legacy non-Agency mortgage assets. And this policy does very little to increase the number and quality of market participants. PPIP, for example, was initially designed to employ 5 asset managers, and these asset managers were to be chosen based on experience with legacy troubled assets. It is understandable why Treasury may desire to limit the program in this way. Under PPIP, taxpayer money is invested as equity alongside private funds, and the Government also provides leverage. This unprecedented and truly novel Government program is being instituted against a backdrop of economic crisis, political outrage and distrust regarding nearly anything to do with Wall Street, and very large Government deficits. While the program is the result of creative thinking within Treasury and the Administration’s economic policy team, and is no doubt one among many needed bold steps to address the current economic and financial crisis, the complexity of the program and the need for close Governmental oversight requires that the number of managers be severely limited. As a result, there will be only a small number of managers chosen and these managers will be from among the ranks of those with experience in distressed mortgage assets.15 The capital pools that invest under TALF 2 and PPIP will be the same capital pools that have been investing in the non-Agency market since it became distressed last year. Since this invested capital has experienced significant losses in this time period16, there also is a question as to how willing this capital is to continue investing in this product. While new distressed mortgage funds have been raised, there have only been a handful, and the largest of them have approximately $3 billion of capital. With trillions of dollars of toxic assets clogging the banking system, policies that promote private investing in the mortgage space should seek to tap much larger pools of capital.
A Mortgage Recovery Backstop Will Return Traditional Investors to the Legacy Non-Agency Market
Our mortgage recovery backstop proposal would greatly increase the number and quality of investors in legacy mortgage assets. Because the top portion of each loan (which flows through to the top portion of each pool of loans) is guaranteed, these portions become AAA risk. Some portion below that level will be investment grade. And a smaller portion of each loan and pool will be rated sub-investment grade.
The effects on current holders of these securities will be immediate, as banks, insurance companies and other regulated financial institutions will receive immediate capital relief on the assets they hold, in addition to the capital benefits from expected mark to market gains.
15
Application for Treasury Investment in a Legacy Securities Public-Private Investment Fund, U.S. Dept. of the Treasury. April 6, 2009. “Treasury expects to approve 5 Fund Manager to raise private capital to invest in joint investment programs with Treasury. The number of Fund Managers may be increased depending on treasury’s evaluation of the applications received and determination of what is in the best interests of taxpayers. Treasury will consider expanding the program through additional funding in the future.” 16
A Bloomberg article from April 6, 2009 by Sree Vidya Bhaktavatsalam cites returns for the largest distressed mortgage fund of -25% for the 4
th quarter of 2008 and -33% since the opening of the fund in October 2007.
June 2009 24
The healthier regulated institutions will in fact become potential buyers of the investment grade tranches of these assets since they will no longer suffer a capital penalty for holding them. Mutual funds with investment grade mandates and foreign sources of capital, which buy enormous amounts of Treasury and Agency debt, will also buy the new highly rated tranches of non-Agency debt.
A Solution that De-levers the Market and More Quickly Returns it to the Private Sphere
The current credit crisis was the result of excessive leverage. This leverage was provided by large pools of domestic and foreign capital seeking investment grade and AAA risk. Now that many of these investments in the non-Agency market have been downgraded to junk, they no longer fit the investment mandate of these sorts of real money investors17. Current Government policy looks to the current pool of potential buyers of these distressed assets and provides inexpensive leverage to them to buy at higher prices. A mortgage recovery backstop program like the one we propose, by contrast, seeks to support prices without adding leverage to the system by bringing back to the market real money buyers whose investment mandates generally target safer, lower and less levered returns on investment. Government policy that increases the number and quality of these sorts of participants will more quickly restore the legacy non-Agency market to the private market, thereby allowing a quicker and easier Government exit.
A De-levered Market Will Be More Stable and Require Less Government Intervention
The pathway to a more stable market for legacy non-Agency mortgage assets will determine sustainability. If credit risk is not addressed, prices that have been supported by inexpensive leverage will revert to distressed levels once leverage is taken away. Consequently, the current programs may require a very long term commitment of taxpayer dollars in the form of leverage. But when the Government provides leverage or otherwise partners with private investors, there is significant unknown risk that such entanglements will ultimately hamper efforts by the administration to restore functioning credit markets and to return markets to the private sphere. The swift political firestorm over the AIG bonuses is a case in point.
A mortgage recovery backstop does not entangle private firms with the Government. Like the market for Treasuries or Agency paper, institutional delineation remains clear. Furthermore, Government involvement is not open-ended. As legacy assets mature, the guarantees will expire – no negotiations over exit strategy will be required. TARP, TALF and PPIP will all require complicated exit strategies, strategies that cannot be accurately mapped today. This lack of clarity, while currently unavoidable, makes returning markets back to the private sector more difficult as there are uncertain political negotiations ahead in each case.
17
The ratings driven mandate of mutual funds and the ratings driven RWA methodology for bank capital are both pro-cyclical to the detriment of investors and market stability. A par bond rated AAA by the rating agencies required little research from far too many investment managers to make an investment and it required banks to hold very little capital against the asset. The combination led to enormous losses. The same asset now trades at 40 cents on the dollar and the risk of significant loss has significantly diminished compared to risk at 100 cents on the dollar. Ironically, even though there is now lower risk to a buyer, the bond is rated at junk because there will in fact be loss of principal. The fact that the market is compensating the investor for principal loss through low pricing does not figure into the rating of the security. As a result, the same institutions that bought these assets in droves at par now, in the case of investment grade mandated funds, can no longer buy or, in the case of banks and insurance companies, cannot hold these assets efficiently.
June 2009 25
Summary
A mortgage recovery backstop effectively and efficiently makes the market for legacy non-Agency mortgage assets functional again by addressing risk rather than the market for leverage. By addressing risk, the following beneficial results can be achieved:
More and higher quality (“real money”) buyers will be brought back into the mortgage market.
More private money from pools with a lower return on capital hurdle will result in a less levered and more stable mortgage market.
Returning capital to the mortgage markets will ultimately contribute to the reestablishment of trust within the market for new originations and the stabilization of the housing market in general.
Without the need for large amounts of Government leverage and equity co-investments, there will be far less need for highly complex Government policies.
Less entanglement between the private and public spheres will return the mortgage markets to the private sphere more quickly.
Less entanglement will lower the political risk that comes with large Government intervention, including both risks to the taxpayer and risks to private enterprise.
Less entanglement means a clear and easy exit strategy for the Government.
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MAKING MODIFICATIONS WORK
In this section we discuss current Government mortgage modification policy. We begin by analyzing the politics of mortgage modifications. Actual and proposed policy has introduced significant political risk into the market for legacy non-Agency mortgage assets. We show how this risk is in part due to misalignment between borrowers, servicers and lenders. Finally, we demonstrate how a mortgage recovery backstop can serve to align the interests of stakeholders within a modification program, and can also help to create alignment among Government policies.
Modifications and Political Risk
The prices of legacy non-Agency mortgage assets are depressed because investors are incorporating their risk aversion to tail scenarios into pricing. Political risk is no small part of the risk that the market is pricing into the tail. Observers of the political response to the mortgage crisis cannot be faulted for fearing that Government policy will be pro-cyclical with regard to the value of non-Agency mortgage assets – the lower home values go, the larger the potential foreclosure crisis, the more the Government will seek to benefit borrowers over investors. The logic is the following:
A home foreclosure crisis affecting millions of families needs to be avoided to allay suffering, and to prevent damage to the value of surrounding real estate and to the very fabric of the communities that would be hardest hit.
To keep people in their homes, mortgages need to be affordable and homeowners need incentives to pay their mortgage and to pay to maintain the property.
Mortgages that are not affordable need to be changed.
Options include refinancing into a new mortgage or modifying existing mortgages; the Government has instituted programs to do both.
o We and many investors support the Hope for Homeowners refinance program as the preferred solution to the foreclosure crisis; to date only a handful of H4H mortgages have been re-financed18 and obstacles remain.19
o Modifications have strong political support and attempts have been made to spur
modifications through creating the fear of greater losses through bankruptcy cram-down legislation.
18
Hope for Homeowners Program: Monthly Report to Congress for January 2009, FHA. 22 loans had been processed as of January 24, 2009, “an increase of 21 loans from December 2008 Report to Congress.” The report goes on to note that “While interest thus far has been lower than expected and some challenges remain, these preliminary figures are a positive sign that there is interest in the program.” 19
A subject for a different Paper is how to fix the Hope for Homeowners program. H4H has not worked for a variety of different reasons, all of which can be fixed in our view. The main obstacles have been lack of a clear policy regarding 2nd liens and the conflicts of interest of 2
nd lien holders who are also servicers, high costs and fees, burdensome paperwork and
monitoring requirements, regulatory risk to the originator’s core FHA business and early pay default risk (FHA puts back loans to originators if borrowers miss their first payment, making originations too risky for any 3
rd party originator who doesn’t
already own the loans, as would be the case for loans in securitizations).
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Pending legislation provides a “Servicer Safe Harbor” that aims to protect servicers who carry out
modifications under HAMP from being sued by investors under existing contracts that discourage modifications or otherwise require servicers to maximize the value of mortgages under contract.20
Servicers are not disinterested participants in the mortgage market.21
o For one, under HAMP the Government pays servicers a large incentive fee22 for each loan they modify and subsequent success fees of $1000 per year for up to three years for each loan modification that does not re-default.
o Secondly, in RMBS servicers are generally required to advance delinquent scheduled principal and interest payments to the securitization trust on a timely basis. These advances do not accrue any interest and are reimbursed only upon a delinquent loan’s return to performing status or upon a final realization (pay-off in full, short sale or liquidation of foreclosed real estate). Therefore, these advances are always money losing (given the 0% interest rate received) compared to alternative uses of the capital and have created tremendous cash flow issues for servicers given the unprecedented levels of delinquency. Modifications allow servicers to avoid losses from advances.
o Thirdly, defaults and liquidations lead to the loss of servicing rights and the loss of the net present value of the expected stream of servicing fees. Indeed, servicers could experience an additional windfall if they can modify the term of loans to 480 months, as allowed under HAMP, or otherwise lengthen the duration of their servicing asset. Servicers, in theory, benefit from modifications that do not reduce principal and do not create equity for the homeowner (in contrast to the Hope for Homeowners program) because such modifications are likely to keep the borrower in the current loan for longer by reducing the options to refinance or sell the property and pre-pay.
20
To the extent that the main objection to a mortgage recovery backstop is one grounded in concerns about moral hazard (which is the concern that a government guarantee is effectively a bailout of a bad investment that will condition future investors to ignore risk and make more bad investments), we would argue that our proposal is better viewed as compensation for potential value lost through an aggressive modification program than as a bailout. Also, investors will pay some premium for the guarantee. 21
The four largest 2nd
lien holders are also very large servicers. This Paper does not address issues regarding the interests of 2
nd lien holders, but it is important to note that the interests of servicers/2
nd lien holders are not always aligned with the
interests of 1st
lien holders and borrowers. Specifically, a refinancing program such as H4H could greatly benefit borrowers and the real estate market as a whole by reducing principal and creating equity for the borrower. Borrowers who have equity in their homes are much more likely to remain current on their mortgage payments, avoid foreclosure and otherwise keep up the property, all to the benefit of surrounding real estate values. Principal forgiveness and early pre-payment typically benefits the 1
st lien holder to the detriment of the 2
nd lien holder due to the extinguishment of the 2
nd lien under H4H.
Therefore, it is very difficult to incentivize servicer/2nd
lien holders to pursue H4H originations. For a full discussion of servicer/2
nd lien conflicts with investors and borrowers see “conflicts and Interest & Tranche Warfare Move Front and
Center.” Amherst Mortgage Insight, Laurie Goodman, May 27, 2009. 22
The incentive fee is $1000 for each completed modification and an extra $500 for those loans where the borrower was current before modification. The fees are payable after a successful 3 or 4 months “Trial Period” (period varies depending on whether the initial loan was in default).
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Without contractual constraints servicers would be incentivized to modify mortgages on any hint
of borrower distress without regard to the effect on the value of the loan. This is why investor contracts with servicers include provisions that require the servicer to act in the best interest of the investor, and in many cases either limit the number of loans that can be modified (typically 5% of the pool) or forbid modifications entirely. If servicers cease to be aligned with investors through a combination of HAMP and a Servicer Safe Harbor, there is near certainty that modification programs will unnecessarily impair the value of the collateral.
Re-default rates have been high in modifications to date – modifications that don’t work are likely to be costlier to investors than a timely liquidation.
If high re-default rates continue, there is the possibility of further rounds of modifications, which will in turn further condition borrowers to believe that lenders will pursue alternatives to their foreclosure rights and potentially reinforce re-default tendencies.
The following diagram, which shows prices for various mortgage securities shortly before and after the announcement of HAMP, illustrate the mortgage market’s negative reaction to the announcement of HAMP.
A successful mortgage modification program does not need to be a zero-sum game, where a fixed pool of value gets divided up between investors, servicers and borrowers. A policy that encourages successful modifications by supporting asset values through a mortgage recovery backstop will benefit all stakeholders. If Government policy does not align the interests of all market participants, it is not just investors who will suffer -- future borrowers will be harmed through significantly higher borrowing costs.
Aligning Lenders, Borrowers and Servicers
There is currently a great opportunity to align the interests of investors, servicers, borrowers and Government policy. All stakeholders share an interest in avoiding a foreclosure crisis. All stakeholders share an interest in supporting the value of residential real estate. However, where suspicion exists that value is being unfairly transferred from investors to servicers and borrowers, or that value will be transferred without end, it will be very hard to generate support among all investors for modification plans, even when modifications will ultimately serve investors well by protecting overall residential real estate values. The mortgage cram-down debate was one such battlefield which demonstrated conflicting interests and concerns over misalignment of incentives.
June 2009 29
A mortgage recovery backstop for modified mortgages will align the interests of investors, servicers, borrowers and the Government. Investors, who currently fear getting “pennies on the dollar” in tail scenarios, should become supportive of HAMP. The Government, by insuring tail risk, will have an incentive to promote modification policies that have a higher chance of success. This might mean, for example, promoting modifications that are affordable relative to the entire debt load of a consumer. Under current policy, first lien lenders are asked to lower coupons to as low as 2% and to potentially accept principal write-downs, while unsecured creditors like credit card lenders can continue to charge double digit rates against the full credit balance of the same customer.
Aligning Government Programs
A mortgage recovery backstop will also create better alignment between the Government’s modification programs and its TARP and other programs for the benefit of financial institutions. It makes little sense for the Government to promote a modification program that unnecessarily lowers asset values while at the same time it is providing capital to banks and other financial institutions to fill the hole created from these same depressed valuations.
June 2009 30
CONCLUSION
Government is and will continue to play a key role is returning credit markets to health. A functional market for legacy non-Agency mortgage assets is necessary to achieving this goal. This Paper has analyzed why, from among Government policies to date, the Home Price Decline Payments program within HAMP to provide a mortgage recovery backstop, if properly expanded to cover 75% of newly underwritten home values for all modified mortgages, would have a materially positive effect in achieving these public policy goals. The following table summarizes our views of these different programs.
Expanding HPDP into a full-fledged mortgage recovery backstop is the missing policy piece which will align market participants and align Government policies. A functional market for legacy non-Agency mortgage assets combined with a successful modification program will work with, rather than against, the efforts being made under TARP to shore up the nation’s financial system. By bringing in more market participants, who can invest on a less levered basis, Government can more quickly and easily disentangle itself from the private credit markets, hastening economic recovery.
June 2009 31
APPENDIX
Press Release, Department of the Treasury, May 14, 2009, text of HPDP program. Home Price Decline Protection Incentives to Protect Against Falling Home Prices: This initiative provides lenders additional incentives for modifications where home price declines have been most severe and lenders fear these declines may persist. These incentives will encourage servicers to undertake more modifications by assuring that incremental investor losses will be partially offset.
To encourage the modification of more mortgages and enable more families to keep their homes, the Administration, building on insights pioneered by Chairman Bair and the FDIC, has developed an innovative payment that provides compensation based on recent home price declines, structured as a simple cash payment on every eligible loan. Home Price Decline Protection (HPDP) incentives are designed to address investor concerns that recent home price declines may persist. Together the incentive payments on all modified homes will help cover the incremental collateral loss on those modifications that do not succeed. HPDP payments will be linked to the rate of recent home price decline in a local housing market, as well as the average cost of a home in that market.
Increases Number of Loans that Are Modified: Making Home Affordable will make payments totaling up to $10 billion to encourage lenders, servicers and investors to modify rather than foreclose by addressing concerns that home price declines will persist in the future. This should increase the number of modifications completed under the MHA program in markets hardest hit by falling home prices.
How The Program Works: Payments will be based on the total number of modified loans that successfully complete the
modification trial period and remain in the modification program. Each successful modification will be eligible for a HPDP incentive, up to a cap for HPDP incentives
of $10 billion. If the trial modification remains successful, 1/24th of the HPDP incentive will accrue to the
lender/investor each month for up to 24 months. HPDP incentive payments will be made at the end of the first and second year of the modification.
Calculation of HPDP Incentives: HPDP incentive amounts will be calculated based on a formula incorporating:
o Declines in average local market home prices over recent quarters prior to the quarter in which the loan was modified based on housing price indices; and
o The average price of a home in each particular market, since the potential loss due to a given rate of home price decline will be larger in higher cost areas.
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