Alternatives To Foreclosure
Mortgage foreclosure is a tragic and traumatic event for any homeowner. It is the legal process whereby property rights to one's home are stripped away due to inability to maintain the obligations of a mortgage loan. The actual process varies by State of residence, and can take anywhere from 6 weeks to 18 months, depending on the jurisdiction.
In almost every State, foreclosure involves the auction of a property by a representative of the county court or the lender in order to satisfy the debt on the house. The investor usually gives instructions to the loan servicer to bid at or near the value of the debt. The servicer usually wins the bid because foreclosure generally occurs only when the debt is greater than the value of the property. The servicer or investor must then manage the house, provide repairs, and sell it through normal real estate channels, hoping to lower the final loss from what would otherwise have been realized if a third-party bidder had purchased the property at the foreclosure auction.
Foreclosure is then not only a costly experience for the family losing a home, but can be a lengthy and expensive procedure for the loan investor, the servicer, and any insuring agency that is also involved. Contrary to popularly held beliefs, these mortgage market participants lose money on nearly all foreclosures. Fortunately, these firms have discovered they can benefit themselves and homeowners if foreclosure can be avoided. A forthcoming HUD report to Congress examines various strategies now used to protect borrowers while mitigating the loss experienced by the lenders.1
Lessons from the private sector
By 1985 the mortgage industry was feeling the effects of several overlapping events: high interest rates from the Federal Reserve Board's October 1979 decision to allow interest rates to freely rise; foreclosures coming out of the national recession in 1981 and 1982 and the ensuing farm- and industrial-belt depression; a new economic environment in which rapid inflation could no longer be counted on to support troubled homeowners with low-downpayment mortgages; and a bevy of new and untested mortgage products developed to help portfolio lenders cope with volatile interest rates, but whose default risks appeared to be higher than those of traditional level-payment mortgages. All of these circumstances led to higher loan defaults. With the collapse of the oil-patch economy in 1986 came more defaults and foreclosures and even the insolvency of several private mortgage insurers. Then the stock market crash of 1987 and the retrenchment of the financial industry led to an escalation of foreclosures in the Northeast. These events sparked the beginning of large-scale efforts by national institutions to understand and mitigate the problem of single-family home foreclosures. By 1991, as the foreclosure rates of the oil-patch and Northeastern States were passing their peaks, mortgage finance institutions were establishing serious and wide-sweeping loss-mitigation policies with loan servicers. These basic approaches continue to undergo fine-tuning, but the changes that took place in the early 1990s truly ushered in a new era in how the mortgage industry treats financially troubled homeowners.
Industry sources suggest that 70 to 80 percent of all loans at 90-day delinquency can still be reinstated without assistance. Borrowers must be encouraged to proceed in that direction; the greatest danger is that borrowers will give up hope or panic and either walk away from their properties or use the legal system to forestall what they believe to be inevitable foreclosures. When a borrower's delinquency extends past day 90, the servicer must change from delinquency management to loss mitigation. After 3 months of loan delinquency, the organization bearing the credit risk faces a potential for some type of loss, and foreclosure with the associated property management and final sale, is the most costly option. Loss mitigation means finding some resolution short of foreclosure. These resolutions are typically called loan workouts. The least costly workout options are those that keep borrowers in their homes, and the next best are those that assist borrowers in getting out of the now burdensome financial responsibilities of homeownership in a more dignified and less costly manner than foreclosure.
The option used for homeowners with truly temporary, one-time difficulties is the advance claim. In this case the insurer pays the servicer the amount of the delinquency in return for a promissory note from the borrower. The mortgage loan is then made whole, and the insurer can collect part or all of the advance from the borrower over time.
The next option for keeping borrowers with temporary problems in their homes is a forbearance plan. This option is used for borrowers who have temporary reductions in income but have long-term prospects for increases in income that could again sustain the mortgage obligations. It is also used when troubled borrowers are working to sell properties on their own. The forbearance period can extend from 6 to 18 months or longer, depending on the borrower's circumstances. During this time borrowers may be initially permitted to make reduced monthly payments, working to eliminate the delinquency through increased payments during the latter part of the forbearance period. Because insurers, Fannie Mae, and Freddie Mac typically consider forbearance plans a servicer matter, they are rare in practice, leading some homeowners to lose their homes unnecessarily.
For permanent reductions in income, the only way to assist troubled borrowers to keep their homes is through loan modification. Loan documents can be modified in any way, but the two most common are interest-rate reductions and term extensions. Loans with above-market interest rates can be refinanced to the market rate and borrowers charged whatever portion of the standard origination fee they can afford. If the interest rate is already at or below the current rate, then monthly payments can be permanently reduced by extending the term of the mortgage, even starting a new 30-year amortization schedule.
Such modifications can be done quickly and inexpensively for loans held in portfolio, and in recent years they have become easier to implement for those loans in mortgage-backed security (MBS) pools. Fannie Mae and the U.S. Department of Veterans Affairs readily agree to allow servicers to buy qualifying loans out of MBS pools, modify them, and then sell them back to the agency to hold in a retained portfolio. Freddie Mac, which has a security structure different from that of Fannie Mae, performs the purchase itself after the servicer completes negotiations with the borrower.
In many cases borrowers are better off getting out of their existing homes. There may be a need to find employment elsewhere, a divorce settlement that requires selling the property, reductions in income that necessitate moving to lower cost housing, or a deceased borrower with an estate to be liquidated. Whatever the reason, there are three options currently available for borrowers who must give up their homes. The first is selling the home with a loan assumption. This is valuable if the mortgage carries a below-market interest rate that would make its sale more attractive, and in cases in which the assumption permits the purchaser to obtain a higher loan-to-value ratio than could otherwise be attained. Credit agencies will waive the due-on-sale clause of fixed-rate mortgage contracts as needed to assist troubled borrowers sell their properties and avoid foreclosure.
Borrowers who must move and who have negative equity in their properties may be eligible for preforeclosure sales in which the insurer or secondary market agency (Fannie Mae or Freddie Mac) helps the borrower market the home and covers any loss at the time of settlement. Borrowers can be asked to contribute to the loss according to their financial abilities. This has become the number one loss-mitigation tool of the 1990s. Industry sources indicate that preforeclosure sales prices are generally at least 5 percent higher than those for homes with foreclosure labels on them, and all of the costs and uncertainties associated with foreclosure and property management are eliminated. Borrowers benefit by avoiding the indignity of a foreclosure.
The last option short of foreclosure is for the borrower to voluntarily convey property rights to the lender/servicer. This is an old technique and, as it involves the homeowner signing over the deed to the property, is called a deed in-lieu-of-foreclosure, or simply a deed-in-lieu.
Attempting loan workouts is risky; if they succeed, there are cost savings over foreclosure, but if they fail and foreclosure must be pursued anyway, default resolution has greater costs. That means that the entire decision about whether or not to offer foreclosure alternatives, from the creditor's perspective, comes down to understanding two probabilities: the break-even probability of workout success and the probability of an individual borrower succeeding in a workout. A break-even probability indicates how many workout offers must succeed in order for the total cost of all workouts (successes and failures) to equal the cost of immediate foreclosure on all loans. If the individual's success probability exceeds the break-even level, then it is financially prudent to offer that person a workout. This concept was formalized by Ambrose and Capone.2
The Ambrose-Capone study is instructive as it simulates break-even probabilities for four major types of workouts: loan modifications, forbearance, preforeclosure sales, and deeds-in-lieu. It also takes into account uncertainties with respect to the time it takes to foreclose on and sell a property, considers a number of economic environments and initial loan-to-value ratios, and accounts for borrower opportunities to cure defaults. In circumstances in which housing prices are either stable or have experienced some decline,modifications have the lowest break-even probabilities (18 to 25 percent). That means that lenders can take the most chances with these workouts. Each success can cover losses from between four and five failures. In areas where there has been no housing market downturn, pre-foreclosure sales have the lowest break-even probability (20 percent), and modifications have the highest (42 percent). Deeds-in-lieu and forbearance break-even rates are each around 30 percent.
Since there is strong evidence that break-even probabilities tend to be well below 50 percent, borrowers whose chances of success are 50 percent or better certainly should be given workout opportunities. Even borrowers whose probability of success is somewhat less than 50 percent still should be given a workout opportunity. Of course, how low a probability of success the credit-risk bearer can accept depends upon its having enough defaulted loans to take advantage of the law of large numbers. That is, to ensure that offering alternatives to foreclosure will reduce the cost of loan defaults, one must have enough defaults to know that the probabilities on each loan will turn into certainties in the aggregate. Thus, national insurers and agencies are in prime positions to remove this risk from small lenders and servicers. By dealing with larger total numbers of defaulted loans, the national organizations can profitably offer workouts even to households with success probabilities very near the break-even levels.
Successes and failures at FHA
The Federal Housing Administration (FHA) has had a difficult history with respect to loss-mitigation and foreclosure-avoidance measures. Its original neglect of the issue was not unlike other mortgage insurers and guarantee agencies. At 90-day default, servicers would turn accounts over to foreclosure attorneys for immediate collection or foreclosure. But in 1974 the courts ruled (Brown v. Lynn) that HUD's insured borrowers were a protected class under the National Housing Act and required post-default assistance.3 In response, FHA developed its Single-Family Mortgage Assignment Program. Under the assignment program, FHA pays full insurance claims to lenders/servicers and becomes both the investor in and servicer of the loans. Borrowers are granted a period of reduced or suspended payments, which create long-term accounts receivable with FHA. The forbearance period can last up to 36 months after which borrowers have up to 10 years beyond mortgage contract maturity to pay off their entire debt.
From the perspective of borrowers, the assignment program has been a mixed success. Only a minority have cured their default, while many more families have postponed foreclosure for long periods of time. Some families simply avoid foreclosure but never fully recover. Based on FHA's experience from 1984 to 1993, a reasonably accurate distribution of outcomes can be constructed. During the first 10 years after families enter the assignment program, approximately 15 percent fully recover; another 25 percent sell their homes, many at prices insufficient to pay off the entire debt; and roughly 50 percent lose their homes through foreclosure.
The remaining 10 percent retain possession after 10 years but are so heavily in debt that it is highly unlikely that they will ever fully reinstate the mortgage. From a narrow financial perspective, the assignment program has been a failure for FHA. Because the program allows many families who eventually will lose their homes to remain in them for long periods without making regular mortgage payments, losses from carrying these mortgages are high. The expected loss on each assigned loan is roughly 48 percent of the outstanding loan balance, while outright foreclosures without assignment incur an average loss of 38 percent. That is, with an average loan balance of $58,000, the dollar loss per assigned loan is $28,000, which is $6,000 more than the cost of a direct foreclosure from the insured portfolio (without the use of an assignment option). The assignment program only affects a small part of the seriously delinquent loans handled by FHA each year. Only 15 percent of all serious defaults qualify for the single-family assignment program. Many loans fail to qualify because the default is judged not to have been beyond the control of the borrower or because the borrower is judged not to have reasonable prospects of resuming full payments within 36 months and repaying all accrued arrearages within 10 years past the mortgage maturity date. Because of a combination of statutory, budget, and judicial restrictions, HUD has been limited in its abilities to offer other options to borrowers who have become seriously delinquent but who do not qualify for assignment. Therefore, FHA has missed some important opportunities for loss mitigation and possibly some opportunities to help distressed borrowers avoid foreclosure.
Recently, however, FHA has begun to provide one alternative to families who are ineligible for assignment or who waive their rights to assignment. The Stewart B. McKinney Homelessness Assistance Amendments Act of 1988 authorized FHA to pay insurance claims on mortgagor house sales in lieu of property foreclosures. FHA avoids expenses related to foreclosure processing and subsequent property management and disposition and homeowners are released from an unmanageable property. FHA conducted a demonstration of the value of preforeclosure sales from October 1991 to September 1994 in three cities--Atlanta, Denver, and Phoenix.
A HUD evaluation studied the experience of more than 1,900 cases that entered the demonstration program through March 31, 1993.4 Successful sales rates varied across demonstration sites, but in total averaged 58 percent across sites. Another 5 percent of participants used the reprieve from foreclosure processing to cure their loans, and an additional 8 percent voluntarily transferred property deeds to FHA after failed sales efforts. Only 28 percent were referred back to servicers for foreclosure. Each successful sale generated $5,900 in savings on claims and avoided property management expenses. In contrast, properties that were either returned for foreclosure or had titles deeded to FHA cost HUD $2,600 in time cost during demonstration participation. Overall, each program participant saved HUD an expected net cost of $2,900. Subsequently, FHA has extended the preforeclosure sales option to all cases where foreclosure is a likely outcome, and HUD now expects even higher savings on each sale due to improvements in program design. Based on an expectation of 10,800 participants per year, national implementation would generate a total annual savings of $58 million.
FHA and the private mortgage market are still learning from the experience of the last 10 years -there is room for more improvements. While the private sector has been successful in applying loss-mitigation and borrower-protection techniques, it has failed to take full advantage of them. Servicers must generally prove to insurers and credit agencies that they have provided a good faith attempt at helping borrowers to cure loan defaults before initiating foreclosure, but not that they have made a good-faith effort in loan workouts. This asymmetry is also apparent in the workout approval process. Insurers and credit agencies generally must approve servicer applications for workouts but not servicer denials of workouts to borrowers in default. Fannie Mae has been the first to reverse this policy, as it now requires servicers to provide a recommendation on all noncured loans.
Uneven application of these techniques is further demonstrated when institutions concentrate their loss-mitigation efforts in areas of the country experiencing the worst problems, so that servicers in other areas have less incentive to pursue workouts. There are some notable exceptions to this situation, such as Fannie Mae grading servicer performance in curing defaults against regional averages, and both Fannie Mae and Freddie Mac waiving approvals if there will be no cost to them.
FHA has not taken full advantage of cost-saving foreclosure-avoidance techniques. The pending report to Congress cited at the beginning of this article lays out a potential framework that would allow FHA to catch up with the private market in this important area of foreclosure avoidance and loss mitigation.
What does the future hold? Certainly, the entire mortgage industry hopes that it does not have to face another long series of regional housing market declines like those experienced over the past 15 years. But if it does, the now standard practice of looking at foreclosure as a last resort will help strengthen homeownership, reduce house price declines, and maintain a healthier system of lending and insuring home mortgages.
Brent W. Ambrose and Charles A. Capone, Jr., "Borrower Workouts and Optimal Foreclosures of Single-Family Mortgage Loans,"unpublished manuscript, University of Wisconsin-Milwaukee, School of Business Administration, 1993. 385 Fed. Supp. 986 (1974); 392 Fed. Supp. 559 (1975). Evaluation of the Federal Housing Administration Preforeclosure Sale Demonstration, U.S. Department of Housing and Urban Development, June 1994.