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James Witman, VP
Capital Markets Group
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Accounting for Loan Cures in Your Modeling
In general terms, a loan can be considered cured when it is brought current from a state of delinquency. For the purposes of this article, we focus on loans curing from a state of foreclosure – the final delinquency state before liquidation. The borrower (the mortgagor) can resume making mortgage payments after delinquency has progressed to this stage of foreclosure, or, the loan may be modified by the lender. Typically, a loan is considered ‘cured’ if all delinquent PITI (Principal, Interest, Taxes and Insurance) payments, late fees and foreclosure costs are paid in full. The cure must take place before the mortgaged property becomes ‘REO’ (Real Estate Owned) and is assumed by the lender. If this occurs, the borrower is removed of further liability except in cases where a deficiency judgment exists. In this article, we will focus on those instances when mortgage loans are brought forward by borrowers.
After a loan has become delinquent, a lender has the following options: begin foreclosure proceedings, accept a short sale, accept a deed in lieu of foreclosure, or modify the loan. A loan may progress rapidly through the delinquency process and enter foreclosure within a few months, or more slowly if the borrower makes intermittent mortgage payments. Once foreclosure proceedings have commenced, the lender must adhere to state mandated rules, schedules and filing restrictions. This will have an important impact on timelines affecting overall cash flows in the lender’s portfolio.
In past rising real estate markets, the lender often initiated and progressed through foreclosures as quickly as possible in order to recoup their investment via the sale of the property and free up capital. Banks are in the business of lending, not owning real estate. Of course, this was still dependent on their current overall portfolio value and capital reserves. Curing a delinquent loan in an environment of rapidly rising real estate values didn’t necessarily have the same financial incentive as it may today.
Consider the following research from JP Morgan, where the first graph (left) indicates delinquency percentages over the past decade and the second illustrates the number of months a Prime sector of loans remains in foreclosure. Not surprisingly, foreclosures have increased dramatically since 2005.
Months in foreclosure directly affect the incentive, capacity and willingness for a borrower to cure their loan and become current. The longer the loan is in delinquency, the more fees accrue and the lower the mortgage cure rate becomes. This is seen clearly in the chart below, where the cure rate has plummeted and then flat-lined near 1%. These circumstances have resulted in skyrocketing loan delinquency servicing costs. Banks simply don’t have the necessary man power today to efficiently maneuver through the foreclosure process created by the ever increasing number.
(* JPM – Securitized Products Weekly – US Fixed Income)
“Liquidation timelines continue to stretch longer, and the longer period in delinquency should pressure severities higher…”
Real World Cure in Your Model
In a portfolio management model, a user most likely would want to enter the percentage of loans projected to cure from a foreclosed status to a current status. Entering a certain percentage as ‘projected cures’ should reduce the foreclosure status ‘bucket’ by the same percentage amount. This should have no effect on loans in any other delinquency status (i.e., 30-59 days delinquent, etc.). The valuation model should keep the original projected percentage for the foreclosure bucket in order to calculate the costs for these loans. In general, any loan in foreclosure will accrue foreclosure costs associated with managing that foreclosure, even if it cures at some future point.
For example:
A financial institution has a mortgage portfolio that happens to be 96% current at the cutoff date and in turn uses this number to project a current status for the months to come. Four percent of the loans in the portfolio are currently in foreclosure and this number is used for the projection of the foreclosure bucket. If the lender assumes a 25% cure rate, this will reduce the projected foreclosure number to a total of 1% of the loans in the portfolio (25% X 4%). For cost purposes, the foreclosure bucket will remain 4%, however, the projected foreclosure bucket will actually become 3% of the portfolio [4%- (25% X 4%)]. The 1% reduction from the foreclosure bucket will now be added to the ‘Current’ status bucket. Therefore, the percentage of loans that will actually fall into the ‘current’ projected bucket will now be 97% of the portfolio [96%+ (25% X 4%)]. This foreclosure calculation will have important ramifications on income and costs.
Predicting a Cure Rate
What factors influence a borrower to cure a loan?
Ability to pay the loan
- Income situation has changed for the better (possibly re-employed)
Capacity to the pay the loan
- Additional, private financing secured
Willingness to pay the loan
- Fear of losing property motivates borrower to bring the loan current
- Concern over ruining their credit rating with a completed foreclosure
- Potential upward change in the market in which the mortgagor could realize a profit on the sale of the property
Historically, the borrower’s ability or capacity to pay the loan was the primary influence to cure the loan. However, in dramatically appreciating markets or in the more recent depreciating markets, a borrower’s willingness to cure appears to be just as critical as their ability to pay. Borrowers are less willing to become current for a property that is depreciating rather than appreciating. Also, due to high LTV’s, a borrower’s current equity may be small or possibly negative. Recently, many borrowers are making the decision to stop making payments (even though they have the ability to pay) and walk away from ownership in a negative equity situation. Moreover, growing delinquency costs are affecting both their willingness and ability to cure the loan.
If the loan does not ‘cure’, the property will be foreclosed upon and the lender (Mortgagee) will take possession of the property. The lender will not only have a shortfall of the PITI payments since the loan became delinquent, but also will have acquired late fees and interest due. There also are major variable costs connected to the actual foreclosure process. Ultimately, the costs associated with this process can be determined by the size of the lenders’ servicing operations and the average foreclosure timeline. Included in the costs are the foreclosure administrative fees as well as the losses generated by the maintenance and disposal of the actual property.
Here is a breakdown of the Lender’s typical foreclosure and liquidation costs:
- Cost of funds of overdue payments
- Advance Costs (Advances are made only on delinquent loans)
- Optional additional costs, depending on loan characteristics
- Mortgage insurance reimbursement or VA loan guarantee (if VA loan)
- Servicing recourse percentage
- Administrative foreclosure costs: non-reimbursable costs associated with a completed foreclosure that are not affected by mortgage insurance or by recourse
- Lost revenue once the owners stop paying
- REO expenses: cost of real estate commissions and other costs associated with disposing of a property including:
- Property Maintenance
- Property taxes on the home
- Insurance for the home
- Legal fees (fees to pay lawyers and court filing fees)
These fees add up to an average bank loss of $55,000 – $65,000 per foreclosure. Homeowners spend an average of $5,000- $10,000 in late charges, interest, attorney fees, and other charges to cure a loan.
How far along the foreclosure timeline a loan progresses before it cures will affect the magnitude of these costs realized in a loan portfolio valuation. A proper definition of “months in foreclosure” is the average number of months from initiation of foreclosure to completion of property sale to a third party. Other than the actual fixed costs associated with the foreclosure process, this time line is the primary driver of the majority of costs associated with this process, affecting the bank’s ‘cost of funds’. If a loan cures, all of these costs should be reduced and the liquidations costs will be non-existent.
As Mike Carnes stated in his article (MSR Market) in last quarter’s MIAC perspectives: “Longer foreclosure timelines impact the timing of losses and therefore negatively impact loss severity due to higher interest advances and other carrying costs such as maintenance fees, property taxes, etc. The longer timelines are largely dependent upon servicer capacity, as well as a firm’s ability to adapt to government guidelines such as HAMP”.
There a couple schools of thought about when a loan should cure in a model:
- A loan cures anywhere along the foreclosure timeline. For our purpose, taking into account a portfolio concept, we will make the assumption that the average cure takes place in the 5th month of a 10-month timeline.
- A loan cures at the very end of the time line (before an actual sale). This means that just before the bank takes the property into its inventory as Real Estate Owned the loan is paid and becomes current.
The diagram below depicts a single loan as a point of example. ‘Today’ represents the beginning of your projected foreclosure timeline in your portfolio. Cash flow projections begin at this point.
As depicted in scenario 1, the loan cures in the fifth month. In the second scenario, there is NO cure and the loan proceeds to the REO stage.
In Scenario 1, when a loan cures in the fifth month, this results in less overall foreclosure cost and a subsequent increase in income. Once the loan becomes current, it provides income by way of mortgage payments for the last five months of the timeline. When the loan cures, it provides income from servicing fees, ancillary income and possibly float and late fees. (There is also the unlikely possibility of prepayment income). In contrast, during the first five months of delinquency, the loan accrued costs related to the administration of the foreclosure process, including the cost of funds resulting from overdue payments and additional, previously mentioned costs.
In Scenario 2, no cure takes place, the loan progresses through the entire foreclosure timeline, defaults and becomes an REO property. It will have accrued the maximum amount of servicing costs and brought in zero income since it entered foreclosure. At this point in the process there is no longer the option for the borrower to cure the loan. The lender will take ownership of the property and the borrower is no longer liable for the (foreclosure costs) or the (principle loan balance) unless the court has issued a deficiency judgment (see judicial foreclosure proceedings below).
In a servicing portfolio, twelve principal cash flow strips are recognized:
Overall, there should be no income recognized from a loan in foreclosure, there are only costs to the servicer (lender) at this stage. When a loan moves from foreclosure to actual liquidation, separate liquidation (REO) costs are incurred.
There are at least two different scenarios essential to a bank’s MSR or Whole loan valuation model with regard to a cure concept. In each instance of a cash flow projection, the mortgage manager will want to see most (if not all) income component cash flows increase (depending on type of loan and investor). Here is an example of cash flows from a single loan given a NO cure scenario versus a scenario with a cure rate of 25%. (Twenty five percent is obviously an exaggeration given an entire portfolio. This is for illustrative purposes only.) Obviously, because there are fewer loans projected to be in a foreclosure status, overall foreclosure costs decrease and servicing fees increase.
Table 1 represents one income cash flow, one cost cash flow and the overall percentage of the loans (in this case one loan) surviving in each future month.
There will be instances where the percentage of loans curing will actually decrease the overall percentage of loans liquidating in a portfolio, thereby increasing the total overall loan survival projection for the entire pool of loans (as is seen in the table above). MIAC Analytics provides cure integration for all of these concepts and scenarios.
In a comprehensive mortgage valuation model, foreclosure costs are further affected by the survival percentage mentioned above, because loans that happen to be in foreclosure have an increased chance of actually liquidating versus those that are in other delinquency buckets. (This can be shown from the same tranche of loans from JPMorgan’s loan performance data below).
Source: J.P.Morgan, Loan Performance
Therefore, a proper cure model will account for the projected delinquency buckets as well as the probability of actually defaulting.
How Do You Choose a Cure Percentage? Aside from what is taking place in the market at the time of the projection, what actual characteristics of a loan will affect the cure Percentage the most?
| Original Underwriting criteria and capacity: Whether the loan is Prime, Alt A, or Subprime is a determining factor in the probability of cure. Looking at historical data provided by research institutions also is important. |
- LTV
- Fico Score
- Type of Loan
- Current interest rate
- State of origination (for foreclosure timeline and loss severity)
A higher LTV (at the time of valuation) overall tends to lead to a lower cure percentage rate because of reduced borrower willingness to pay. A lower FICO score on average tends to indicate a lower cure percentage. A higher current interest rate directly affects the borrower’s mortgage payment and ability to pay and foretells a lower cure percentage. These three factors, as well as the original DTI, are fairly accurate indicators of the type of loan originally underwritten. Not surprisingly, a prime loan has an overall higher probability of curing versus an Alt-A loan versus a subprime loan.
Additionally, there may be a big difference in loans curing in a state where the foreclosure process is extremely time consuming. For the most part, a Judicial Foreclosure Process takes longer than a Trustee Sale and therefore accrues more costs leading to a decreased rate of ‘cure’.
Servicers (lenders) have management options regarding loans that have gone delinquent:
- Aggressively modify delinquent loans (rate reductions and principal forgiveness)
- Flush the delinquency pipeline as quickly as possible (short sales), or
- Stay “par for the course” – where eventually the loan will either cure or liquidate.
All three of these approaches yield varying numbers of loans resulting in foreclosure. If Servicers follow methods ‘1’ or ‘2’ above, this will reduce or eliminate the number of loans entering the foreclosure stage, but may actually increase the internal cure percentage (for calculations of value) given there are fewer overall loans in foreclosure. (Again, for purposes of this article, the cure rate is applied only to loans currently moving through the foreclosure process.) With the first two approaches, the servicer has forgone having these loans move from an actual delinquency state to the default state. With regard to methods ‘1’ and ‘3’ above, many of these “cured” loans actually re-default and return to some stage of delinquency, eventually resulting in a foreclosure status again.
Servicers need to consider the percentage of modified loans that will actually re-default in order to determine their true cure percentage.
The Current Market
The following data demonstrates the 6 months between 03/2010 - 09/2010 for a prime sector tranche of loans (which is part of a $1 Trillion + sector) which have seen an average cure rate of just 1.2%. This example does not distinguish “cured” loans brought current by the borrower and loans that have come current due to lender modifications. Although both result in the loans becoming current, there is a big difference between the former being the borrower’s option and the latter being the lender’s option.
Source: J.P Morgan, Loan Performance
Cure rates at the moment are at an all time low. Loans that are currently in foreclosure have a propensity to complete the process (albeit at a slower rate than in the past). One major reason is the current decline in the job market and high unemployment rates. Borrowers in foreclosure don’t seem to have the ability or capacity to make future payments on their mortgages, nor catch up on all the payments missed. It is no secret the job market has caused a glut of properties to fall into foreclosure and REO status.
In addition to these market factors, institutions need to look at or examine their historical delinquency roll rates for their own portfolios and identify loans coming out of foreclosure due to borrower repayment.
Other Questions a mortgage manager should consider are:
- What groups of loans are curing in a falling market? (depreciating market)
- What groups of loans are curing in a rising market? (appreciating market)
In conclusion, the probability of loans curing has to do with a complex combination of factors that include: the borrower’s current ability, capacity and willingness to pay; overall equity in the property; state laws regarding foreclosure proceedings that affect longevity and severity costs; and the original underwriting standards of the loan. All of this information, combined with research on the current real estate and job markets and an institution’s historical cure rate should enable a mortgage servicing manager to properly integrate cure into their valuation model. The new MIAC|DS (one of our integrated portfolio management systems) release adds this comprehensive cure modeling enhancement to assist you in tracking portfolio risk and realizing income that may otherwise have been overlooked.
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