(Qualification: I have extensive experience in this field, but have not worked in it in some time. The opinions expressed herein are my own and not representative of any employer.)
When a mortgage lender makes loans, they usually do one of three things with them:
- Bundle (pool) them and sell them to a GSE (Fannie Mae or Freddie Mac). Generally, the loans sold have similar characteristics (rate, loan-to-value ratio, term, etc.). The GSEs have what's called a "conforming" loan limit, which right now is $417,000. Any loans with higher balances cannot be sold to the GSEs. Selling the loans gives the lender the immediate capital to keep lending, but they're not necessarily all that profitable to the lender.
As Fannie and Freddie struggle with their liquidity problems, the question is how many loans they'll continue to buy. If Fannie and Freddie can't raise the capital to continue to buy the loans, lenders will not have as much money to use to continue making loans.
- Bundle (pool) them and sell them as a package on the secondary market. This is where we got into the SIV/CDO mess. While some non-conforming loans, with higher loan-to-value ratios (say, up to 90% of a property's value) and other riskier characteristics, were packaged and sold in much the same way as the GSE loans to non-GSEs, many were put into weird, funky investment vehicles, often combined with other debt instruments (we're hearing about this with auto loans right now).
Most of the stuff that went into their weird groups included loans that were highly profitable to originate and not so hot for anyone else except the investment community. And trust me, it's not just "subprime". Exotic loans like payment option ARMs, interest only loans, and even hybrid payment option ARMs (where increasing balances that result from unpaid interest are forbidden) were all lumped together. Now, nobody will touch these weird packages with a ten foot pole. That forces the lender to keep them on the books, which causes a lack of liquidity, since a) it was the sales of those packages that kept money flowing to make more loans, and b) in the case of banks and thrifts, requires them to maintain higher loss reserves in the event of default. The less liquidity the lender has, the fewer loans it can make, cutting fee income and reducing profitability.
Now let's talk about the "teaser freeze":
Those same lenders who have to keep the loans on the books are the ones who take the hit (assuming no mortgage insurace) when a borrower defaults. For loans that are backed with mortgage insurance, the lender will recoup most of the costs, assuming that a) the loss isn't the result of a natural disaster and b) the insurer is solvent. A lot of lenders offer higher LTV loans (over 80%) without mortgage insurance in return for a premium rate. These are not subprime loans. But they're also not saleable to the GSEs, so that means the lender takes their chances: they either sell it like in #2 above, or they keep it betting that the higher interest rates will offset any defaults.
I was taught a long time ago that, in order for a lender NOT to lose money in the foreclosure process, the maximum loan-to-value (LTV)ratio for a mortgage loan was 90%. In other words, if more than 90% of a property's value is financed, the lender will take a loss. In a rapidly declining market, I'd venture a guess that close to half of mortgages wtih LTVs higher than 80% pose a threat of loss to the lender.
So what's a lender to do?
- For loans that can't be sold or whose characteristics the lender likes, the lender retains them as portfolio product. That means that the lender owns them and, assuming no mortgage insurance, takes their chances on potential losses. As fewer and fewer loans are being sold on the secondary market (whether or not they're to the GSEs), more and more are being retained on the books. From these, a lender's earning come from fees and interest payments.
The stated goal of a lender who holds a loan in portfolio is to keep the borrower(s) paying as much interest as possible for as long as possible. This is one reason refinances are such a goldmine for lenders: most of the interest a borrower pays is in the first few years of the life of the loan, and that means "churning" loans via refi means higher interest payments to the lender. In addition, as I referred to above, most portfolio loans have the potential to rack up higher losses for the lender, so keeping the borrower paying is the best strategy there is.
When loss mitigation efforts start, one of the first things the lender does is assess the borrower's ability to pay. What they don't tell you is that the financial statements that are submitted are hacked to pieces by the person considering the borrower's needs. Families are told to reduce food costs, entertainment and clothing expenses, and to default on credit cards and other unsecured debt in favor of the mortgage. All assets...paid-off cars, retirement accounts, and the like...have to be liquidated first in order to satisfy the lender before a workout can be completed. Some repayment arrangements involve adding the payments the borrower missed onto the back end of the loan (capitalization) and either recalculating the payments for the remainder of the loan or over an extended loan period. It's rare to see a rate reduction, because that's the lender's bread-and-butter. And plenty of borrowers say no.
Now some of the borrowers are, to put it mildly, a little strange. "I'd rather buy my kid a bike for Christmas", or "I have to pay the taxidermist to have my dear, beloved kitty stuffed" are not figments of an overactive imagination. But others just don't want to live like paupers in a house whose value is crashing, sacrificing their quality of life for their credit rating.
When a lender negotiates a short payoff (also called a short sale), it means that the lender agrees to take whatever the borrower can sell the property for in lieu of foreclosing. Again, the borrower is forced to liquidate everything in order to pay toward the shortage. Additionally, realtors and brokers are nickel and dimed in fees. And in many states, there isn't enough time to even negotiate a short payoff because foreclosures are non-judicial (they don't require court action) and can, in some cases, be completed in a matter of weeks. In a soft market, good luck trying to sell a house at market value (whatever that may be) fast enough to go through all the lender's hoops for financial statements, tax returns, appraisals and the like AND still meet the closing date.
There are some significant caveats to loss mitigation efforts that involve modification to the original loan terms which is what happens when payments are added to the balance, when the loan term is changed, or when any parts of the original contract are changed to enable the borrower to keep paying.
- If the loan has mortgage insurance, the lender may have to get the insurers permission to modify the loan. If the mortgage insurer has created it's own pools of loans that it has sold investments in, the loans in the pools may not be modifiable, depending on the terms of the investment. There may be a clause in the contract that says that, if the lender wants to modify the loan, they would lose the insurance. And what lender, knowing their loss is insured, would want to do THAT?
- If the loan was sold as part of one of those weird packages I described in #2 above, the same applies. Loans securitized as a package may not be modifiable, unless the lender buys it back. And since the lender doesn't own the loan anymore, why would they want it back?
- If the loan is a second or a home equity line of credit behind a first lien, the senior lienholder (whoever holds the first mortage) has to agree to the deal, since all of the loan documents have to be re-recorded in the proper order (which assures that the first lienholder remains in first position, which also gives them first dibs on the equity in the property). And, if the first lien is also in default and is on their way into foreclosure, the second lender (who may also hold the first) may not want to work anything out on the second, preferring instead to write it off and try to save the first. If the senior lienholder goes to foreclosure sale and the second doesn't pay the first to "cure" the default or pay the whole first off, in most cases the second lien is wiped out, meaning that whoever buys the property (the bank or anyone else) has no liability for the amount of the second mortgage.
The second mortgage aspect above in number three is very important, since the number of PM2s (purchase money seconds) went through the roof in the last few years, as did the number of HELOCs (home equity lines of credit).
The short of it is this: lenders put themselves in a really bad place, and nothing I've heard from the Fed or Treasury really fixes anything. Since under the "teaser freeze" deal borrowers have to prove they can't make a higher payment (and knowing how much sacrifice the borrower has to show to prove that), I'd bet a significant number will walk rather than throw everything they have at a house that's not worth what they owe on it.