The FDIC Does It Again

FDIC Chairman Sheila Bair has struck again-with yet another creative response to the ongoing mortgage crisis. Chairman Bair has a history of being ahead of just about everyone else in Washington with proposals to respond to the crisis in a manner that is doable and fair. This time it's the Home Ownership Preservation or HOP loan, and the FDIC estimates about one million loans-make that one million homeowners in trouble-might be eligible.

Any mortgage loan taken out between January 1, 2003 and June 30, 2007 by an owner-occupant at a level below the FHA conforming loan limit that was unaffordable at origination would be eligible. What does "unaffordable at origination" mean? According to the FDIC website, it means that when the borrower took out the loan, his or her total housing payment-for principal and interest on the loan, taxes and insurance-exceeded 40% of income. And, according to an FDIC conference call May 7, that does not mean that the amount the borrower actually paid at origination exceeds 40%; it means that the amount the borrower would have paid had escrows for taxes and insurance been included and had the initial payment been for both principal and interest, at the fully-indexed rate, not the teaser rate. This makes the proposal far more powerful than it appears at first glance.

The way HOP would work is that a servicer would apply to Treasury for a loan to the borrower that would pay down 20% of the current mortgage. In exchange, the servicer would agree to modify its loan into a fully-amortizing fixed rate mortgage for the balance of the mortgage term, with interest set so that the borrower's monthly mortgage payment, including taxes and insurance, would not exceed 35% of the borrower's verified current income. Interest on the modified loan could be no higher than Freddie Mac's published rate for 30-year fixed rate mortgages, and if that interest rate were not low enough to get down to 35% of income, the lender would have to set a lower rate. And no negative amortization, prepayment penalties or deferred interest would be allowed.

The lender would pay the Treasury the first five years of interest on the Treasury loan up front, and would also subordinate its interest to the Treasury's. Thus, if the borrower defaulted or the property was transferred, the Treasury would get paid first-giving the lender a real incentive to make the loan work. The borrower would not pay anything on the Treasury loan for the first five years, and then would pay off the entire principal (with interest at Treasury's rate) during the remaining 25 years of the larger mortgage.

In addition to creating affordable mortgages the appeal of the HOP program lies in three primary characteristics:

• It leaves the mortgages in their existing pools, and, according to the FDIC, requires alterations that are totally consistent with current Pooling and Servicing Agreements (PSAs)
• It does not affect the interest of subordinate lien-holders, which means they can't hold up the process of modification
• The amount of and interest rate on the modified mortgage are not dependent on appraisal of the property, but rather only on the borrower's verified current income

Like all proposals that attempt to deal with this difficult situation, HOP has its flaws:

• Eligibility is dependent on information that lenders should have in their files, but may well not, at least not accurately, as we know that at origination of many loans now in trouble there was either no verification of income, and/or the amount "verified" was incorrect
• To retain consistency with the PSAs, this proposal, like many before it, requires the servicer, not the borrower or someone acting on the borrower's behalf, to initiate the process; so far, servicers have been slow on the draw, to put it mildly
• The Treasury loan could, in some circumstances, generate an unaffordable "payment shock" in the fifth year when the borrower needs to start paying it down; the FDIC's own examples would take the borrower up to a 40% debt to income ratio, even assuming that the borrower's income grew 1.5% annually

But HOP is a creative, constructive addition to the dialog. Maybe its largest flaw is one that Chairman Bair desperately wanted to avoid: it requires legislation. Let's hope it gets serious consideration by Congress and a fair hearing by the White House.