Having essentially conceded the failure of its cornerstone load modification program to achieve widespread mortgage relief, the Obama administration is changing tack. Its new strategy is to focus its attention on specific regional markets, rather than to address the entire national market with one program.

Specifically, the new initiative will allocate $1.5 Billion to the handful of states that have witnessed 20%+ declines in housing prices: California, Florida, Nevada, Arizona, and Michigan. “There will be a formula for allocating funding among eligible states that will be based on home price declines and unemployment.  Eligible [Housing Finance Agencies] HFAs that would like to participate must submit a program design to Treasury.  Program designs must meet funding requirements under the Emergency Economic Stabilization Act of 2008 (EESA).” It seems then that the responsibility to develop specific solutions will rest ultimately not with the federal government, but with the organizations that receive the funds.

This initiative is a recognition that the housing crisis is composed of a number of local crises, rather than one cohesive nationwide crisis. There are disparities in housing prices, sales, delinquencies, even interest rates, that exist between states, sometimes even between counties. For example, the delinquency rate in Florida is much higher than in California, even though prices have fallen about the same in both states. Thus, it makes the most sense that unique relief programs be developed for each state, or even each locality.

A number of ideas have already been mooted, including “measures for unemployed homeowners, programs to assist borrowers owing more than their home is now worth, programs that help address challenges arising from second mortgages; or other programs encouraging sustainable and affordable homeownership.” In fact, unemployment, underwater borrowers, and second mortgages have all served as obstacles to national relief efforts, and it is important that now they can and will be taken into account when designing programs.

For example, unemployment has made it difficult for many borrowers with temporary loan modifications to obtain permanent modifications, since they couldn’t even make payments during the trial stage. As a result, the state of Pennsylvania developed a program that will lend $60,000 to unemployed homeowners for up to three years, to be used to pay their mortgage as they look for work. It’s unlikely that California could afford such a plan ["Pennsylvania's (plan) is great but we probably have more unemployed people in San Diego County than they have in Pennsylvania."], but it could work in a state like Michigan.

In addition, underwater borrowers have found it difficult to achieve either loan modification or refinancing.  “About one-third of California mortgage borrowers owe more than their home’s value. Californians in foreclosure owe an average of $140,000 more than their home’s value…But banks have fiercely resisted efforts to get them to reduce the principal owed on those underwater homes.” Finally, borrowers with second mortgages have found it difficult to convince one lender – let alone two! – that they deserve a modification. State plans could overcome these obstacles by rolling both mortgages together in the case of the latter, and work with lenders to reduce principal in the case of the former. Due to the local nature of this program, the precise terms would depend on local circumstances.

If there’s any consensus surrounding current loan modification efforts, it is that they aren’t working. Depending on whose numbers you believe, between 1% and 2% of all eligible borrowers have had their mortgages permanently modified. While the figures for temporary modifications are more impressive, experts argue that most of these borrowers aren’t ultimately being helped, since they will likely default anyway. In this sense, loan modification is actually worsening their plight. [Chart courtesy of WSJ].

Anyone who has applied for a loan modification can surely attest that the most banks are usually willing to offer is a slight (and often temporary) reduction in one’s interest rate and/or lengthening the term of the mortgage. As advocates for borrowers point out, such efforts are quite in-effective since they do nothing to ease the long-term financial burden. Moreover, they don’t account for the fact that for many borrowers, the problem is not that their monthly payments are unaffordable but that their mortgages exceed the value of their homes. The issue for these borrowers is not they are unable to repay their mortgages, but that it is no longer economical to do so.

What’s the solution to this problem? The answer is principal reduction. Borrowers who are having trouble repaying their mortgages would be helped both over the short-term by a lower monthly payment, and over the long-term via a lower debt burden. Those whose mortgages are underwater, meanwhile, would have their equity restored, and thus have more to lose by “strategically defaulting.”

It is a common misconception that loan modification was “invented” by the Obama administration to combat the current mortgage crisis. On the contrary, they existed long before the government catapulted them into prominence. Despite the fact that loan modifications require less paperwork and are inexpensive to process, however, they have been rare and characterized by drawn-out processes because it was (and still is) difficult to persuade one’s lender to voluntarily modify his mortgage. It had become the norm, then, for borrowers to instead apply for a refinancing, which is expensive and contingent on one’s credit score, but easy to execute for those who are approved.

In light of the Federal Government’s Home Affordable Modification Plan (HAMP), however, the tables have turned completely. Under the plan, lenders are incentivized (such that the costs to borrowers are theoretically nil) to modify loans for at-risk borrowers. Such modifications typically involve reduced interest rates, although some lenders have been known to cut the principal as well. Of course, it is now common knowledge that by almost every measure, this program has been an abysmal failure. Only 66,000 borrowers (as of Decemeber 31) have been approved for permanent modifications, far less than the 3-4 million that was initially touted.

In response, the government has taken to chastising lenders that aren’t aggressive enough in modifying loans, in the form of frequent “report cards.” Lenders blame borrowers, naturally, for not providing the necessary paperwork, and borrowers recriminate that the documentation demands are too onerous. The government’s latest attempt to remedy this discontent is to streamline the paperwork requirements so that borrowers need only to provide a request form for modification, proof of income, and authorization for the lender to check their tax history via the IRS. Despite these hurdles and the fact that delays of many months before being accepted (or rejected, for that matter) are common, the program still holds great appeal for borrowers. In fact, some borrowers are deliberately not making their mortgage payments, in a subtle attempt to demonstrate their financial plight to their lenders.

As a result of this shift and the simultaneous tightening of lending standards, it has become quite difficult to refinance a mortgage. The government has responded by unveiling a parallel program, this one aimed at refinancing. All loans that are owned by Fannie Mae and Freddie Mac (themselves “owned” by the government) are automatically eligible for refinancing. Even underwater loans – up to 125% Loan-to-Value – can be refinanced. Otherwise, the only option for those rejected for loan modification and desperate to refinance, is an FHA refinancing.

Given that mortgage rates are hovering around record lows, refinancing for many borrowers would achieve comparable cost savings to modification. One has to wonder, then, if after the expiration of HAMP and the return of the mortgage market to normal functioning (admittedly, this is an uncertain prospect) if the pendulum will swing back in favor of refinancing. With that possibility in mind, borrowers should think twice about deliberately skipping mortgage payments to increase their chances of modification, because such will also dent their chances of getting refinanced. At the same time, the fact that mortgage rates are projected by many to begin rising in 2010, the window on viable refinancing could soon close.

In short, it seems that for those of you who are genuinely at-risk of defaulting, keep talking to your lender about a loan modification. For everyone else, refinancing is probably still your best – and most realistic – option.

Nearly one year old, the federal government’s loan modification efforts continue to languish. In an attempt to galvanize the program, it has taken to releasing updates and report cards with increasing frequency. Unfortunately, these too appear to be having little success, which is why I have taken it upon myself to write my own progress report, for your viewing pleasure.

According to the latest figures, over 650,000 loans have entered the trial modification stage, during which point they must demonstrate their sincerity, eligibility, and capability, before they can be converted to permanent modifications. Specifically, they must make 3 payments under the new terms and submit certain documentation, that proves they are legitimately entitled to a modified loan. You would think that this wouldn’t be too difficult, but to-date, only 30,000 temporary modifications have been converted.

Naturally, there is no shortage of blame to go around. The government is blamed for not spurring more trial modifications (it originally estimated the pool of eligible borrowers at four to seven million). Lenders are blamed both for taking too long and for not granting increased leniency to borrowers, some of which are still seeing an increase in their monthly payments following modifications. Lenders counter that borrowers are also to blame, both for failing to make the required 3 payments under the trial modification and for not submitting the necessary paperwork.

Representative Jeb Hensarling’s assessment reflects what everyone is undoubtedly thinking: “Taxpayer-funded foreclosure mitigation programs have been an abject failure.” He and is leading the campaign to completely abolish the program. I’m partially playing devil’s advocate here, but perhaps it’s time to face the fact that this initiative was designed to fail. 25% of borrowers that received temporary modifications ultimately defaulted, while a handful of modifications have been handed to borrowers that weren’t even behind on making payments. Then, there are those that deliberately fell behind on their payments in order to receive payments, and those that are “naturally” behind by avoiding modifications because of the hit to their credit score that comes with the delinquency denotation reported to the rating agencies.

For better or worse, the program refuses to die; a new executive order prevents lenders from canceling temporary modifications “scheduled to expire before Jan. 31 for any reason other than property eligibility requirements.” Progressive Congressman, such as Barney Frank, are advocating alternatives, such as a program in Pennsylvania that makes low-interest loans to the unemployed that can be used to make mortgage payments. He is also trying to re-introduce a “cram-down” bill, that would give judges discretionary power to modify mortgages as they see fit. Finally, under pressure from the government, lenders have redoubled their efforts, in some cases bringing on more staff and opening new centers staffed exclusively to make loan modifications. Maybe there is hope after all…

Shamed from its failure to prevent the housing bubble and wary of being stripped of its regulatory powers by the still gestating Consumer Financial Protections Agency, the Federal Reserve is stepping into high gear. Six months ago, the amended Truth in Lending Act (TILA) officially went into effect, and followed this up last month with the implementation of new “Regulation Z” to this act.

For those of you unfamiliar with this enhancement in regulation, the amended TLIA mandated an increase in transparency in the mortgage application process. According to the Fed, this act “requires creditors to give good faith estimates of mortgage loan costs (”early disclosures”) within three business days after receiving a consumer’s application for a mortgage loan and before any fees are collected from the consumer, other than a reasonable fee for obtaining the consumer’s credit history.” Previously, these disclosure rules only applied to primary residences; now they apply to “all dwellings.”

According to the Fed, “Uniformity in creditors’ disclosures is intended to assist consumers in comparison shopping” and prevent them from feeling pressured to close a deal right away. Towards this end, borrowers MUST wait at least 7 days after receiving the initial good-faith estimate before they can close on the loan. During this period, they can thoroughly evaluate the lender’s offer and even consult with other lenders. Additionally, if the final APR rate is off by more than .125% from the good-faith estimate, then borrowers MUST wait another three days before closing.

If the original act was designed to increase transparency during the application process, then the new Regulation Z (which goes into effect immediately, but which lenders technically have 60 days to implement) should increase transparency after the mortgage has already been completed. Specifically, if the loan is sold or transferred to a new lender/investor/institution, then the acquiring entity has 30 days in which to inform the borrower of the change.

This regulation, while seemingly trivial, should address the massive uncertainty that has arisen over the last decade, as mortgages change hands at an increasingly rapid speed. Only recently, with the CDO fiasco, has the complex chain of mortgage lending that stems from origination to “packaging” to investing come to light. For the most part, borrowers are blissfully ignorant to this process; all they care about is to whom they should mail the monthly mortgage payment to. Only recently has this become a problem, as delinquent borrowers have sought loan modifications, but must first track down the current owner and obtain his permission before such is possible. As a result of the new rule, fortunately, the current owner’s identity will no longer be a mystery requiring the prowess of a homicide detective to unravel.

Overall, these regulatory changes do essentially nothing to prevent a repeat housing bubble from inflating. Still, that they increase the transparency of the system is laudable in its own way. Borrowers can no longer complain that they weren’t given adequate time to consider a mortgage offer, or that the original good faith estimate differed drastically from the final numbers, or that they don’t know who owns their mortgage. If knowledge is power, than borrowers now have some muscle!

Loan modifications have been a popular theme on the Mortgage Calculator blog for the last couple weeks, and I plan to continue in that vein with this post. I’ve already covered the process of having a “private” loan modified (one originated/owned by a private lender). Today, I’d like to overview the process for having a “public” loan modified.

First of all, let me explain what I mean by a public loan. I’m primarily referring to loans guaranteed by the Federal Housing Administration (FHA). These loans have historically been available to low-income borrowers, who can apply for a mortgage through the FHA to achieve down-payment assistance and or more affordable mortgages. The second category of “public”mortgages are those held by Fannie Mae and Freddie Mac. These mortgages have always enjoyed an implicit government guarantee. Since the government effectively took control of the mortgage giants, you could say that it has a vested interest in ensuring their solvency, at the very least.

Those that have FHA mortgages are perhaps in the best position when it comes to loan modification. Eligible borrowers typically enjoy a 30% reduction on the interest-accruing balance on their respective mortgages. For as long as they live in the home and stay current on the original mortgage, they are only required to pay interest on the other 70%. When borrowers move out or refinance, however, the entire balance comes due.

Of course, FHA borrowers still have to jump through the same hoops as normal borrowers in order to achieve a modification. In other words, it’s not the FHA that ultimately has the power to approve/deny a modification request, but rather the loan services, which are incentivized by the government to support the program. Still, borrowers who are not yet delinquent on their mortgages probably don’t have a shot of getting approved, and the same is true for borrowers whose financial situations are especially desperate. The most promising candidates are the ones in the middle of the affordability spectrum- those whose mortgage payments aren’t crippling and hence have a realistic chance of avoiding foreclosure with the help of a modification.

Those whose mortgages aren’t guaranteed by the FHA, but are owned by either Fannie Mae or Freddie Mac, are also in a fortunate position. Since Fannie and Freddie are in a government trusteeship, mortgage servicers don’t need the approval of private investors before approving a modification. [For those who aren't sure whether they fall into this category, you can enter your street address here to confirm]. Still, the mortgage services themselves must grant the approval, and as with FHA loans, they are compensated for the government for doing so.

Such servicers are looking for borrowers whose housing payments (principal, interest, taxes, and insurance) exceed 31% of gross monthly income. In this sense, borrowers whose income has fallen (but not disappeared) since taking out their mortgages, and those whose payments have increased (as a result of adjustable rate reset, for example) are the most likely candidates. Typically, such borrowers will have see their interest rate reduced to 2%, though loan balance/principal won’t be adjusted.

As with FHA loans, servicers are looking for borrowers that are in need of aid, but not desperately so. Borrowers without any income won’t qualify, because the risk of foreclosure will still be high after modification. Those with healthy savings or other assets also won’t qualify, since most servicers will judge them capable of making mortgage payments without a reduction. The key is “massaging” your financial position so that you fall into the sweet spot.

The much-maligned Federal loan modification program appears to be gathering momentum, as the Obama administration recently announced that 500,000 mortgage loans have now been modified. This was hailed as a milestone, and the administration claims that it was reached ahead of schedule. Given the program’s slow start (reported in depth by the Mortgage Calculator), it is certainly cause for celebration.

Leading the pack are Citigroup, Wells Fargo, and Lehman Brothers, which have modified 33%, 20%, and 33%, respectively of their eligible loan pools. According to a government report, “In the second quarter, 78% of loan modifications involved actually reducing borrowers’ payments, up from 54% in the first quarter,” which means that “mortgage servicers became less likely to merely add missed payments to the balance of a reworked loan.” Even better, lenders have modified more than two million loans outside the auspices of the government program, through the industry alternative, known as the Hope Now program.

According to the government, the program aims to be even more successful, in terms of both individual lenders and on an aggregate basis. The stated objective remains 3 – 4 million modifications. Towards this end, the government will continue to incentivize lenders and release “report cards” on their progress.

Criticism of the program continues to pour on from all sides, however. Most of it is centered on the notion that the program is both naive and undercapitalized. Asserts one critic, “Borrowers whose mortgages are modified tend to default on the new terms at a high rate. Of the estimated 4.5 million homeowners in foreclosure or headed there with mortgages 90 days or more delinquent, the program ultimately will save only 1 million of them.”

In addition, there is concern that a fresh wave of delinquencies and potential foreclosures threatens to outpace the government’s efforts. To this, Treasury Secretary Geithner offered the following hedged response: “While the pace of loan modifications now exceeds that of new foreclosed loans, a ‘large number of families’ remain at risk of losing homes they might be able to afford if they could change their mortgage terms.”

There is even criticism coming from within the government, much of which is grounded in familiar partisan battles. Republican lawmakers argue that the $75 Billion budgeted for the program is wasteful and unnecessary, while their Democrat counterparts insist that additional funds need to be allocated. Despite the disagreement, “A Congressional Oversight Panel formally urged “Treasury to reconsider the scope, scalability and permanence of the programs designed to minimize the economic impact of foreclosures and consider whether new programs or program enhancements could be adopted.”

Finally, there are concerns that the program continues to benefit lenders and servicers, at the expense of borrowers. Lenders reap financial rewards for modifying loans even when the result is an increase in debt for the borrower. “These Treasury people are all from Wall Street, and they’re not doing anything but protecting Wall Street. They don’t care in the least about protecting homeowners,” argued one lawyer. The government, however, is doing its best to make sure loan modifications are carried out in an upright manner, and is in the process of officially prohibiting the charging of upfront fees in association with modifications. Progress is slow, but at least it’s progress.

Here at the Mortgage Calculator, we try to provide timely updates on the government’s loan modification program. Our last post, on August 6, (”Loan Modification Program could Receive Boost“), detailed the program’s shortcomings, which were responsible for the program’s dismal 9% participation rate. Since then, we’re happy to report that the program has really taken off, as the largest lenders have been shamed by the federal government into submission.

According to Bloomberg News, “Bank of America Corp. and Wells Fargo & Co., among the worst performers of banks in the U.S. government’s main foreclosure prevention plan, stepped up their pace of mortgage modifications by at least 60 percent in August.” Leading the pack is Morgan Stanley’s mortgage origination unit, which has modified over 40% of eligible loans, defined as owner-occupied homes, with a pre-2009 conforming mortgage that is in danger of “imminent default.”

As always, the devil is in the details, since a loan modification doesn’t necessarily lower the risk of default, and doesn’t even translate into a lower payment. “Of loans modified from Jan. 1, 2008, through March 31, 2009, monthly payments increased on 27% and were left unchanged on an additional 27.5%…Many modified mortgages fall delinquent — 25% to 40%, depending on the type of mortgage — often because of homeowners’ loss of income or additional outstanding debt…”

There are a few reasons for these outcomes. First of all, when executing loan modifications, lenders can choose between lowering one’s interest rate (temporarily or permanently), extending the loan term, and cutting principal from the loan amount. In theory, all would seem to lead to lower payments, but as the statistic above attests to, this is the case less than half the time, due primarily to the adding back of deferred taxes. Astonishingly, over 90% of loan modifications lead to higher principal balances.

Advocates argue that this represents the best approach. They point out that mortgage problems for many are a temporary result of unemployment, rather than long-term financial hardship. “A lot of what’s being done is a misplaced focus on modest, long-term relief when what they need is fast, short-term, massive relief (due to job loss),” maintains one economist. This philosophy is reflected in Bank of America’s approach to loan modification, which offers “mortgage forgiveness for three to six months in hopes the borrower will find a new job in that time.”

Those on the other side of the debate argue that this misses the point, and that the focus instead should be on “permanent debt reduction.” Many have begun to direct their attacks on the industry’s Net Present Value model, which is used to asses whether a loan modification is ultimately in the best interest of the lender. According to critics, this model is overly conservative, and leads to an overly high rate of rejection. At the very least, it confirms what cynics have maintained all along- that the mortgage lending industry still does not remain behind the loan modification program.

There’s even a small minority of critics who insist that loan modifications are a bad deal, on the grounds that it damages the credit of borrowers. “Under reporting guidelines set forth by the credit bureaus and the Consumer Data Industry Association, your loan modification will be reported as a ‘Partial Payment Plan.’ Under the FICO scoring method, that designation will lower your credit scores, even if you have never missed a payment.” From a credit standpoint, then, loan modification is not much different from foreclosure that far away from foreclosure, and might ask some to consider whether the consequences justify it.

Outside of this debate are the millions of people still waiting to receive modifications. For every borrower that is emerged “victorious” from the maze of requirements, there are at least 10 more who are stuck in “loan modification hell,” as one columnist put it. Anecdotal reports indicate that the experience is both time-consuming and frustrating; the best advice is to be patient, and to keep a paper-trail.

Option Adjustable Rate Mortgages (ARMs) were just one of many innovative financial products that rose to the fore during the housing bubble. They work by enabling borrowers to select from three options, the size of the payment they wish to make on their mortgage each month. The high payment is fully-amortizing (principal and interest), the middle payment is interest only, and the low payment is a token sum which does not even cover interest. That the bast majority such borrowers opted to make the low payment has led to the characterization of the Option ARM as the Negative Amortization ARM.

Many ARM borrowers actually caught a break after the housing bubble burst, since the consequent lowering of interest rates brought ARM rates down proportionately. Gushed one borrower, whose rate is tied to LIBOR, ““In 2009 I found out I have a 2.5 percent mortgage. That’s not onerous by any standards.” Unfortunately, lower interest rates doesn’t necessarily translate into lower payments.

There is a clause in most Option ARM contracts which states that if/when the loan reaches 60 months in age and/or the balance reaches a cap (110% – 125%), the loan automatically recasts. Essentially what this means is that the borrower must begin to make fully amortizing principal and interest payments; the minimum negative amortizing payment is no longer an option.

Due both to the decline in housing prices and the fact that most Option ARM borrowers elected to make the lowest payments, recasts are beginning to rise. 2011 meanwhile, will likely witness an explosion in recasts, as loans cross the 60-month time limit. According to a recent report by Fitch Ratings, this figure could be as high as 70%. Moreover, “Of the $189 billion securitized Option ARM loans outstanding, 88% have yet to experience a recast event. Of these loans that have not yet recast, 94% have utilized the minimum monthly payment to allow their loans to negatively amortize.”

For a significant portion of Option ARM borrowers, a recast is tantamount to a death sentence. Fitch predicts that ultimately, close to half of such borrowers could default on their mortgages. “They’re probably going to default at a rate that makes subprime look like a walk in the park,” warned one analyst. When you consider that as much as 14% of outstanding mortgages are Option ARMs and that most were used to purchase homes in bubble markets (California, Florida, Nevada, Arizona), the losses will probably be staggering.

Ironically, holders of Option ARMs don’t have many Options when it comes to mitigating the burdens posed by their mortgages. While refinancing could save money over the long-term, it would probably won’t help those who are currently struggling: “Just about anything they refinance into is going to give them higher payments than they have now,” explained one counselor.

Mortgage modifications, meanwhile, are also pretty much off the table, since they are intended to lower one’s mortgage rate rather than to lower one’s payment, directly. ” ‘The problem with these option ARM borrowers is they are already paying a low rate,’ [Barclays Analyst] Deb said, adding that a better solution would involve forgiving part of the loan balance, something that most lenders have been unwilling to do.” Still, if you’re facing such a predicament, it wouldn’t hurt to talk to your lender. As the problems surrounding Option ARMs become more prominent, lenders might become increasingly keen to play ball.

The Mortgage Calculator’s last report on the status of the federal government’s Home Affordable Modification Program (Banks Represent Main Obstacle to Loan Modification) argued that banks were largely to blame for the program’s failure to get off the ground. In an attempt to jump-start modifications, “The administration on Aug. 4 unveiled the first of what will be monthly name and shame exercises, publishing data on the loan-modification efforts of about three dozen companies.”

Three weeks later, however, it doesn’t look like much progress has been made. “Moody’s analyst Celia Chen…said that the number of modifications ‘will have to step up substantially in the remainder of this year in order’ to hit the 1.5 million to 2 million modifications that her firm estimates can be completed under HAMP by 2012,” which is less than half of the target of 4 million set by the government.

Demand for loan modifications is still running strong according to anecdotal evidence, which suggests that the fault lies primarily with the banks. According to government estimates, “Only 9 percent of eligible borrowers had been offered trial loan modifications through June.” By their own admission, banks remain reluctant to participate in the program. “In the Fed’s latest survey of senior loan officers, about 30 percent of banks said they were still tightening standards for both consumer and business loans.”

In some cases, banks have even acted counterproductive to the modification process, by dubiously suggesting that borrowers should deliberately fall behind on their payments in order to qualify for modification. It’s not clear whether such a strategy can ultimately be successful, but from a cost/benefit standpoint, it’s definitely not advisable. Horror stories abound, whereby “the modifications never came….These borrowers burned through retirement savings, destroyed their credit ratings and suffered mental and financial hardship,” and even foreclosure!

The government also deserves some of the blame for not making the program altogether transparent. One columnist seeking to navigate the process himself, wrote: “I discovered, just trying to access the program put me through a torturous weeks-long battle with red tape that made my previous interactions with the RMV and the IRS seem downright fun.” Unfortunately, his experience seems to be typical, and the relative handful of borrowers who were ultimately lucky enough to secure modifications were only able to do so after months of hard work and persistence.