Lisa Malie , SVP Capital Markets Group

      To modify or not modify – that’s the question of the day for mortgage investors and servicers all across the country.  In early March, the Treasury released details of the Home Affordable Modification Program (HAMP) which was first announced in February as part of the Homeowner Affordability and Stability Plan.  At its core, the HAMP provides uniform guidance for loan modifications across the mortgage industry, providing another avenue of assistance for distressed borrowers who would not qualify for the previously announced Hope for Homeowners refinance initiative.
Guidelines for the HAMP provide answers to many of the pertinent questions related to the modification process:

1. Which borrowers/mortgages will qualify for the program?
2. How does the Servicer/Investor (henceforth referred to as Servicer) determine how to modify the loan?
3. How does the Servicer determine if making the modification is in the best interest of the Investor?
4. What is the incentive compensation structure for all parties involved in the modification process?

      After all is said and done, the next question becomes - What is the projected impact to the value of each mortgage asset given the unique terms of each modification?  And more importantly, how will these assets really perform in the short and long-term?

Key to Success

       There are high hopes for potential success through the HAMP.  On the surface, the program seems to address the key issue with the “old” loan modification approach – affordability.  In the old loan modification world, re-default rates were generally high (in the 70% - 80% range) because the modified loan terms did nothing to alleviate the borrowers’ cash flow problem.  Payments were recast on an unpaid principal balance increased through capitalization of arrearages using the original loan terms, generally resulting in an increased monthly payment.  If anything, this approach provided the borrower nothing more than a “stay of execution” from the foreclosure process.

      The HAMP, on the other hand, is predicated upon reducing the distressed borrower’s payment in an effort to address affordability and post-modification performance.

       Through a waterfall approach, including a reduced interest rate along with the potential for an extended term or principal forbearance, the HAMP targets a front-end debt-to-income ratio of 31% for all loans, with debt defined as first mortgage principal and interest payment + tax and insurance payment + homeowners’ association fees.  Further, the HAMP targets not only delinquent borrowers, but also those in Imminent Default – not delinquent but facing a financial hardship that will make the borrower unable to make mortgage payments in the near future.
To promote the success of the initiative, the HAMP includes two key elements:

1. A Net Present Value Test (NPV Test) designed to limit modifications to only those loans where it is beneficial to the investor
2. Pay for Success Incentives designed to encourage the Borrower – and the Servicer – to keep current on monthly payments post-modification

Applying the Net Present Value Test

      The NPV Test is required for each loan being considered for the HAMP.  The test compares the net present value of the expected cash flows for a loan if modified vs. not modified.  Four cash flow scenarios are valued for the NPV Test:

1. No Modification – Loan Cures
2. No Modification – Loan Defaults
3. Modification – Loan Cures
4. Modification – Loan Re-Defaults

      Probabilities are then assigned to each cash flow scenario to determine the final NPV for modification vs. no modification.  The calculation of these probabilities is based on Mark- to- Market Loan- To- Value, FICO, Starting Debt- To- Income, and Modified Debt- To- Income.  Loans with a positive NPV (that is the modified NPV is projected to be greater than the non-modified NPV) must be modified. 

      The equations for the base NPV model, along with various model inputs, have been provided in the NPV Test guidelines. These model inputs include:

1. Discount Rate
2. CPR
3. REO Stigma or the difference between the sale price of a foreclosed property and the sale price of comparable properties that are not foreclosures
4. Home Price Projection, which is a two-year national home price projection
5. Mortgage Insurance partial claims
6. Foreclosure and REO Disposition Times
7. Foreclosure and REO Expenses and Selling Costs
8. Post modification time to re-default
9. Probability of re-default (formula)

      Model inputs and equations (except discount rates) must be applied consistently across all loans.  Further, only Servicers with $40 Billion or more in assets (or others who receive special permission) will have the option of building and implementing proprietary NPV models for the HAMP.

Incentives and the Impact on Asset Value

      Assuming a loan is NPV positive, and a modification is done, the value of that loan and the servicing on that loan going forward will be impacted by a variety of factors including Pay For Success Incentives paid to the Servicer and the Borrower along with the Payment Reduction Cost Share paid to the Investor in the loan. The Pay For Success incentives give all parties to the modification transaction a vested interest in the performance of these modified loans, with the goal of limiting the potential for re-default. 

1. Servicers will receive up to $1000 per year for up to 3 years for each modified loan that continues to perform
2. Borrowers will receive up to $1000 per year for up to 5 years to be paid toward principal as long as their loan is current

      The Payment Reduction Cost Share is an attempt to compensate the Investor agreeing to a reduction in the future cash streams associated with their investment. The Investor will receive an amount equal to 50% of the payment reduction from 38% to 31% Debt- To-Income for up to 5 years.
Both the Servicer and Investor are eligible for up-front incentives as well for completing the loan modification process.

MIAC Tools and the Modification Process

      MIAC offers a variety of tools to help Servicers and Investors assess the potential viability of a modification for each eligible loan in their portfolio.  Coupled with identifying these loans, MIAC has incorporated the resulting modification-related cash streams into its cash flow engine in order to give clients the ability to evaluate changes in asset value given the terms of the modification and the projected collateral behavior of each loan once modified.  Moreover, the MIAC tools will give users the flexibility to assess a variety of what-if scenarios related to both the NPV Test and the projected post-modification cash flows to provide an understanding of the sensitivity of these calculations to an evolving mortgage market.

      With its open architecture and flexible data model, MIAC’s DataRaptor data management tool provides the perfect framework for identifying loans that would potentially qualify for modification under the HAMP.  Based on the guidelines provided by Treasury, MIAC has pre-configured a decisioning process within the business logic framework of DataRaptor to replicate both the modification waterfall and the final NPV Test. 

      Using this decisioning process, DataRaptor will identify loans potentially eligible for modification based on the initial set of qualifications for the modification program. Loans that do not qualify are removed from the decisioning process and provided a code identifying the reason for disqualification.  Loans that do qualify are then passed through the decisioning process and ultimately reviewed for eligibility through application of the NPV Test.

      While MIAC has pre-configured a decisioning process within DataRaptor, clients have the ability to customize the decisioning process based on their own needs or requirements.  Furthermore, clients can take advantage of DataRaptor’s ability to interface with third party data providers, notably Kroll Factual Data, to procure critical data elements required for the loan modification decisioning process including updated credit reports and automated property valuations.

      Based on the results of the loan modification decisioning process, updated loan parameters can be output from DataRaptor into MIAC’s cash flow engine (WinOAS). WinOAS can then be used to quantify the change in asset value for modified loans based on incorporating cash flows associated with:

1. Pay for Performance Incentives (MSR and/or Whole Loans) and Payment Reduction Cost Share (Whole Loans)
2. Collateral Behavior – adjusted CPR/CDRs on modified loans
3. Anticipated changes to Cost to Service and other revenue and expense items post-modification
4. Changes in loan amortization on modified loans with below market interest rates (similar to hybrid ARMs)

      Clients can then perform sensitivities on various cash flow inputs such as CPRs, CDRs, costs, etc. to help assess the range of risk associated with the loan modification decision.

Will the HAMP Be Successful?

      Although lenders are hopeful about its success, the market appears to be approaching the HAMP with a “wait and see” attitude.  Large lenders are aggressively pursuing distressed borrowers for inclusion in the program with mixed success. While many borrowers have been helped thus far, the response rate of Servicers attempts to reach out to the distressed population within their portfolios has been relatively low. Many lenders have also expressed concern that the program does not adequately address the plight of the payment option ARM borrower, especially without the option of an interest only feature. To mitigate these issues, many lenders have implemented other modification alternatives for portfolio loans that do not qualify under current HAMP guidelines.

      Despite targeting an affordable 31% Front End Debt-To-Income Ratio, participants in the market are concerned that addressing affordability through the monthly payment alone will not result in a drastic reduction in re-default rates. Although early indications suggest that re-defaults on these loan modifications are fewer, they are still almost 60% in many cases. In the end, there are doubts that the program can do enough to address the negative equity position in which most of these borrowers find themselves.

      As lenders both large and small begin to tackle the implementation of this important piece of legislation, MIAC is pleased to offer a variety of software tools and consulting services to allow our clients to actively manage their mortgage assets in this uncertain environment. Ultimately, the decisioning and cash flow tools MIAC can provide will put our clients in a unique position to identify risk and value related to their modified mortgage assets.

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