New Way to Tackle Foreclosures
May 31 2008 - Over the past several weeks, I have discussed a proposal for a new type of mortgage insurance called mortgage payment insurance. Under MPI, insurers would guarantee investors’ timely receipt of mortgage payments after the borrower defaults, as well as protect against loss if the loan goes to foreclosure.
Even though the insurer assumes almost the entire risk of default, because MPI would reduce the interest rate on high-risk loans, such loans would cost the insurer less than traditional mortgage insurance.
Because no insurers offer MPI, at this point it is just a proposal. The idea came from a friend of mine, lawyer Igor Roitburg, who has a patent pending. I have an interest in that patent.
I think that if MPI were available, it could be used immediately to reduce the number of foreclosures and to reduce losses on the foreclosures that do occur. Here’s how it could work for loans in default:
Loans in default that carry traditional mortgage insurance. We estimate that there are 600,000 loans in default that have traditional mortgage insurance. Case-by-case efforts to modify these loans will make only a tiny dent. There are major impediments to such modifications, and even when these obstacles are removed, the process is costly and time-consuming. MPI makes possible wholesale modifications, covering large numbers of loans, that are in the interest of all parties — borrowers, insurers, investors and servicers.
If loans in default carry traditional mortgage insurance, the insurer is already on the hook for the coming loss, up to the cap on the policy. If the proceeds from selling the property do not cover the unpaid balance, including accrued interest plus foreclosure expenses, the investor is protected for any deficiency, up to the cap.
In more normal conditions, deficiencies in coverage seldom arise. In the current market, however, depreciation in house prices has made deficiencies the rule rather than the exception.
Under these circumstances, there’s a way to use MPI to help both the insurer and the investor, and save a significant number of borrowers from foreclosure.
The way to do that would be to convert existing mortgage insurance policies to MPI at the prime interest rate, provided that the monthly mortgage payment would drop by 10 percent or more.
The major benefit would arise when the resulting payment reduction allows the borrower to return to good standing. All three parties would be better off. The downside to the investor would be that some of these loans might cure themselves without having to reduce the rate. Losses to the investor from this, however, would be much smaller than the gains from loans that return to good standing and would not have cured themselves.
Loan servicers should have an interest in making such deals because the resumption of payments also would mean a resumption of servicing fees. When borrowers stop paying, servicing fees stop. As loans are placed in good standing under MPI, servicing fees would resume.
Loans in default that do not have traditional mortgage insurance. When loans in default do not carry insurance, the investors are on the hook for the entire loss.
An insurer would not assume this risk except with a new loan that meets its underwriting requirements and carries an insurance premium scaled to the risk. Such deals must be done one at a time.
But MPI would be an option that facilitates such restructured deals. To meet its requirements for an insurable loan, the insurer would require the investor to write down the loan balance to 90 or 95 percent of the current property value and reduce the interest rate to the prime rate. If there is a second mortgage, the investor would have to negotiate a payoff with that lender.
The investor would take a loss on the modification, but it would be far smaller than the loss that would have resulted from foreclosure of the original loan. The investor might also receive an equity certificate equal to the write-down of the balance (or balances, if there is a second lien), which would entitle it to a share of future appreciation in the house’s value.
The borrower would get a new start with 5 or 10 percent equity, no unpaid interest and a reduced payment based on the lower rate. Because the payment reduction would be partly offset by the addition of a mortgage insurance premium, this plan would work best with higher-rate mortgages.
This application of MPI would be similar to a mortgage-relief proposal under consideration in Congress, but there are some major differences. Interested readers can get a longer paper that discusses them by writing to me.
Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.
Real Estate: A New Way to Tackle Foreclosures
by Jack Guttentag | Washington Post