The sharp increase in interest rates over the last year has made it difficult for mortgage servicers to provide relief to borrowers struggling with their mortgage payments.
Servicers typically assist struggling borrowers with Federal Housing Administration (FHA) loans by buying out the loan from the securitized Ginnie Mae pool. They then change the terms of the loan to decrease the borrower’s monthly payment by reducing the rate to the prevailing market rate, extending the term, or reducing the interest-bearing principal balance via partial claim.
This works well when the prevailing market rates are lower than the original rate on the mortgage because the new lower rate decreases the borrower’s monthly payment. But with mortgage rates rising sharply in 2022, achieving this outcome has become much more difficult.
Urban recently hosted a panel of industry leaders to discuss what changes to the loss mitigation toolkit could help address this issue. They landed on one solution that could help relieve struggling borrowers—regardless of the interest-rate environment.
Why today’s landscape is unique
At the event, Ted Tozer, a nonresident fellow in Urban’s Housing Finance Policy Center, pointed out that “over the last 40 years, falling interest rates have been the foundation of the successful loss mitigation strategies servicers have used.”
Quantifying the issue, Tom Land, vice president of agency relations at JPMorgan Chase & Co., noted, “Approximately 90 percent of the current outstanding Ginnie Mae [mortgages] have rates at [least] 2 percent below the current market rate.”
Thus, using traditional loss mitigation tools and resetting these loans to the market rate would potentially increase the monthly payment rather than decreasing it.
The FHA partial claim currently works as follows: FHA pays the servicer a portion of the outstanding loan balance, which the servicer uses to cure the delinquent principal and interest arrearages. These amounts become an interest-free second loan due when the borrower refinances or sells the home. This cures the delinquency but does not cut the monthly payment—instead, the borrower must resume their original payment.
The panelists broadly agreed that using the remaining partial claim funds to reduce the monthly payment, without requiring that the loan be bought out of the pool, could be a viable solution. After capitalizing arrearages, the servicer would work with the borrower to determine a sustainable payment. However, this amount would be lower than the monthly contractual principal and interest (P&I) payment owed to the mortgage-backed securities investor.
Under this proposal, the servicer would tap leftover partial claim funds to cover the monthly shortfall between the P&I payment made by the borrower and the contractual amount due to the investor. This monthly shortfall would accumulate as an interest-free second lien to be paid back by the borrower when they sell their home or refinance.
Once established, the industry should consider making this a permanent loss mitigation tool. According to Michael Bright, CEO of the Structured Finance Association, “One thing we learned from the COVID experience is that the system starts to break when we use temporary solutions and the temporary solutions keep getting extended while we are searching for real meaningful permanent solutions.” Loss mitigation tools work best when they are standard, predictable, and permanent because investors can model and price for them.
Although this proposal leverages the existing partial claim framework, it could be complicated for consumers. Kurt Johnson, the executive vice president and chief risk and compliance officer at Mr. Cooper, conveyed the importance of clear communication during implementation, saying, “The more consistent we can be as an industry in getting all those concepts across to consumers, the better we will be served as we roll out this program.”
Consumers would need to understand that the funds will keep them current without changing the terms of their loans but that the assistance is not free. Borrowers will owe the interest-free second lien when they sell their homes or refinance their mortgages. Servicers will need to clearly communicate with their consumers and keep homeownership counselors updated on the new loss mitigation option.
Although details still need to be worked out, this solution could work well for FHA (which offers partial claim funds) and the Department of Agriculture (which offers the partial claim–like Mortgage Recovery Advance Program). But the solution won’t assist Department of Veterans Affairs (VA) borrowers, because the agency does not offer a similar program. The VA temporarily offered partial claims during the pandemic, but no permanent funding for such a program exists. Panelists unanimously agreed that a workable loss mitigation solution for veterans is needed as rates rise, especially given the risk of a recession next year. Tozer stressed that partial claims could be expensive for the VA but noted that mortgage guaranty by the VA “is a benefit, and we shouldn’t foreclose on veterans to keep the program profitable.”
Borrowers who become delinquent when rates are high need payment reduction solutions just as much as borrowers who became delinquent when rates were low. It is up to housing finance stakeholders to make this happen. This proposal would offer consumer relief by leveraging existing partial claim infrastructure, thus minimizing the implementation time frame, costs, and complexity. More importantly, it would ensure our loss mitigation toolkit will work for borrowers in all interest-rate environments.
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The Urban Institute podcast, Evidence in Action, inspires changemakers to lead with evidence and act with equity. Co-hosted by Urban President Sarah Rosen Wartell and Executive Vice President Kimberlyn Leary, every episode features in-depth discussions with experts and leaders on topics ranging from how to advance equity, to designing innovative solutions that achieve community impact, to what it means to practice evidence-based leadership.