A Win-Win Strategy to Mitigate Foreclosures with Minimal Taxpayer Exposure

Foreclosures accelerate the falling prices for real estate and mortgage backed securities and are causing a vicious cycle of distress throughout the financial system. Mortgage foreclosures and write downs of mortgage debt deplete Tier 1 Capital which reduces bank lending. This leads to reduced business activity and increased unemployment which leads to further defaults and foreclosures. As foreclosures increase and neighborhoods deteriorate and unemployment rises, the damage will likely be more than economic.

The Federal government should make work out loans available to distressed homeowners enabling them to make payments on their existing mortgages at virtually no risk to the government or taxpayers. The proposed work out loans would be financed by Treasury Notes securely collateralized with a portfolio of first-lien loans with a conservative loan to value ratio. These work out loans places a far smaller burden on the Treasury, at a lower risk to the taxpayer and with greater impact in mitigating foreclosures than other plans currently circulating. Other plans ask the taxpayer to pay for losses from imprudent lending and borrowing practices.

Unless swift action is taken to formulate an effective policy response that prevents new foreclosure filings, the real estate market is set for another round of precipitous declines. The overhang of unsold inventories of homes and the forced dumping of foreclosed properties would dramatically depress real estate prices.  This could contribute to a severe recession that triggers defaults on Credit Default Swaps and could cause yet another shock to the financial system. Nearly a million homes were sold through foreclosure this year. Twice that number are currently somewhere in the foreclosure process. In addition, interest rates reset in 2009 on subprime and Alt A variable mortgages will trigger a new round of foreclosures.  According to Moody’s, as many as 7.3 million homeowners are expected to default on their mortgages within the next two years. Our proposed work out loans should be a key part of any policy response.

The issuance of US Treasury First Lien Mortgage Notes, as we propose, would give policy makers a simple and systematic way to prevent foreclosures in the current environment. These loans are fiscally prudent, politically acceptable and can be implemented immediately under existing law and with funds already authorized by TARP.

Under the new program, government backed loans to provide work out capital to protect distressed homeowners from foreclosure, would go into a capital reserve in an interest bearing escrow account which could be drawn upon to make payments on existing mortgages and prevent loan delinquencies.  This option would be attractive to homeowners wanting to keep their homes and to mortgage holders.  Professor Nouriel Roubini, of the Stern Business School at NYU, estimates, that foreclosure recoveries are averaging 30% in some markets.

The work out loans would be issued for an amount of no more than 40% of the existing mortgage. They would be collateralized by a first lien interest in the real estate to insure full protection to the taxpayer. The existing mortgage holder would be required to agree to subordinate their mortgage.  In exchange, workout capital would be available to service the existing loan.  This would prevent an immediate and substantial cash write off from foreclosure.  The mortgage holder could keep otherwise bad loans on their books generating cash flow.  As a result of this program, mortgage backed securities, containing a portfolio of mortgages, can be maintained in “hold to maturity accounts,” without taking large losses for loan impairment. A bank would be required to certify that a homeowner was in diminished financial circumstances to qualify for a loan.  The mortgage owner and their agent the loan servicing company would have the option to participate.  The program could be open to unemployed or underemployed homeowners who do not have significant assets, as well as homeowners with regular incomes who cannot afford increased payments from mortgage price resets. With the amount of the loan capped at 40% of the principal amount of the existing first mortgage, there should be more than sufficient collateral. However, new appraisals could be required as appropriate.

The interest rate for seven year loans would be set at 260 basis points above 10-year Treasury bonds. (This rate is 100 basis points more than the 160 basis points historical spread of 30-year fixed rate conforming mortgages over Treasuries.) The loan portfolios could be purchased by the Treasury with cash or in a swap for Treasury Notes. This interest rate on the loans would provide funds to cover interest on the Treasury Notes, pay transaction costs and cover any losses, while providing a concessionary interest rate to homeowners.

The loans could be rolled up into a seven year US Treasury First Lien Mortgage Note that would be offered at a discount and not pay a coupon.  Unlike existing mortgage backed securities, these workout capital loans would be transparent and fully collateralized. Conforming programs could be offered in other nations with strongly collateralized real estate loans rolled up into an instrument similar to Brady Bonds. This could be attractive in Eastern Europe, Britain and Spain. Work out capital would be used by distressed homeowners to make mortgage payments on their present mortgage under existing terms or as part of a renegotiation with mortgage service providers. These revised terms could provide interest rate and/or principal reduction to prevent homeowners with negative equity from walking away from their homes. The homeowner and mortgage service provider would negotiate the terms of any new payment schedule and the use of escrowed funds. The escrowed funds could be used to pay the mortgage in its entirety or to pay for alternate months, with the homeowner also making bimonthly payments. The mortgage holder might agree to defer some principal payments and lengthen the term of the loan.

In a typical case, our proposed plan would provide assistance to homeowner X, with a mortgage of $200,000 who is facing distress in meeting payments. Under the proposed program, homeowner X would borrow $80,000, which would be escrowed for the sole purpose of making mortgage payments if he could not. The government would take a first lien for $80,000 and the existing mortgage holder would subordinate its own first lien interest in consideration for the assurance of timely mortgage payments.   In subordinating first position on $80,000, the mortgage owner would be guaranteed to receive $80,000 from the escrowed funds, plus additional payments made by the homeowner. Loans would start coming due after a seven year period. This would provide homeowners ample time to sell the property or refinance. This would also allow homeowners and financial institutions to hold real estate based assets until an economic rebound strengthens the real estate market. Preventing foreclosures and directly supporting real estate prices has not been a priority of policy makers thus far. This potentially catastrophic oversight must be corrected Michael Jaliman is a Senior Adviser with Vantage Partners mjaliman@vantagepartners.com