With many homeowners "under water" on their mortgages, loan servicers need to make more permanent loan modifications — including write-downs of principal — rather than relying on temporary repayment plans, Federal Reserve Chairman Ben Bernanke said Tuesday.
Loan servicers are missing opportunities to engage in workouts that are in the best interests of both lenders and borrowers, Bernanke said, and investors could prevent foreclosures if they allowed loan servicers to act in their own self interests.
The tone of Bernanke’s remarks to the Independent Community Bankers of America at their annual convention in Orlando, Fla., differed markedly from a speech delivered by Treasury Secretary Henry Paulson Monday.
Paulson said the Bush administration’s foreclosure prevention efforts — including a voluntary initiative in which loan servicers are freezing the rates on some adjustable-rate mortgage (ARM) loans — are working, and that there is no need for a government bailout of lenders (see Inman News story).
While Bernanke did not contradict Paulson, he said "scope remains to prevent unnecessary foreclosures," and endorsed a proposal being studied by the Office of Thrift Supervision that would encourage lenders to write down the principal on loans in exchange for the right to share in future appreciation of a home.
Loan servicers participating in the Bush administration’s HOPE NOW alliance estimate that workouts of subprime mortgages rose from around 250,000 in the third quarter of 2007 to 300,000 in the fourth quarter. Workouts involving prime mortgages rose from 150,000 to 175,000 over the same period.
"Despite this progress, delinquency and default rates have risen quickly, and servicers report that they are struggling to keep up with the increased volumes," Bernanke said.
In the past, Bernanke said, lenders and loan servicers have relied on repayment plans when working with troubled borrowers. Repayment plans, in which payments delinquent borrowers have missed are added to regular mortgage payments, are appropriate when homeowners have a temporary job loss or illness.
But Bernanke said there’s anecdotal evidence that, even in best-case scenarios, borrowers given repayment plans re-default at a high rate — especially when the loan arrears are large.
In cases where borrowers owe more on their mortgage than their home is worth, permanent loan modifications — such as interest-rate reductions, extensions of loan terms, or writing down principal — are a better option, Bernanke said.
Declines in short-term interest rates and initiatives involving rate freezes will reduce the impact of interest-rate resets "somewhat," Bernanke said. But the Fed chief expects delinquencies and foreclosures will continue to rise.
The expected rise in foreclosures "could add significantly" to the inventory of vacant unsold homes — already more than 2 million homes at the end of 2007 — and put more downward pressure on prices, Bernanke said.
While lenders have been reducing or freezing interest rates for some borrowers with adjustable-rate mortgages, reductions of principal balance "have been quite rare" Bernanke said.
"Lenders tell us that they are reluctant to write down principal," Bernanke said. "They say that if they were to write down the principal and house prices were to fall further, they could feel pressured to write down principal again."
But if home prices keep falling, lenders may still be susceptible to pressure to make further modifications if home prices keep falling, regardless of whether they write down principal or reduce interest rates, he said.
If loan servicers were permitted to write down enough principal to allow borrowers to refinance into a new loan from another lender, that would protect them from further write-downs, simplify the calculation of expected losses, and eliminate future costs and risks associated with servicing troubled loans.
Bernanke said estimates based on subprime mortgages foreclosed in the fourth quarter of 2007 found total losses exceeding 50 percent of principal balance. Legal, sales and maintenance expenses amounted to more than 10 percent of principal.
The Federal Housing Administration could facilitate such "short payoffs" of loans if Congress gave FHA greater latitude to set underwriting standards and set risk-based premiums for mortgage refinances, and could be done without increasing costs to taxpayers, Bernanke said.
Bernanke said the Bush administration’s FHASecure program, which allows some delinquent ARM borrowers the opportunity to refinance into a fixed-rate, FHA-insured mortgage, is "a step in the right direction."
However, he said, not all borrowers are eligible for the FHASecure program, and some equity is needed to qualify. Bernanke said another obstacle is that second-lien mortgage holders may not be willing to settle or re-subordinate their claims for an FHA loan.
Bernanke said that data collected under the Home Mortgage Disclosure Act suggests that nearly 40 percent of higher-priced home-purchase loans in 2006 involved a "piggyback" second loan.
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