As inflation hits a 40-year high and mortgage rates rise, many people are focused on housing affordability. Indeed, increased interest rates over the past year have increased monthly mortgage payments by approximately 40 percent.
But rising interest rates can affect foreclosures, too. An unsung benefit of low interest rates over the past several years has been that many borrowers have avoided foreclosure. Now that rates are rising, the industry must figure out new ways to prevent losses to borrowers and lenders. A three-step waterfall method that offers payment relief without deferring substantial principal amounts could be an effective solution.
Low mortgage interest rates helped prevent foreclosure and expanded the mortgage-backed securities market
Low interest rates have helped two types of borrowers avoid foreclosure: borrowers at risk of delinquency, who could refinance to lower their monthly mortgage costs and extended their term, and borrowers who became delinquent, who could modify the terms of their mortgage to create an affordable payment.
Low interest rates also helped prevent foreclosure through loan modifications. During the past 40 years of falling rates, mortgage-backed securities (MBS) issuers bought loans out of MBS pools and modified them to lower borrowers’ monthly payments and capitalize delinquent mortgage payments. These issuers included the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, as well as the approximate 430 issuers of Ginnie Mae guaranteed MBS.
Pool issuers, not servicers, buy loans out of an MBS pool. When they do, issuers must finance the purchase of the mortgages with their corporate assets. The bought-out loans are then held on the issuer’s balance sheet.
The interest rate an issuer can offer is directly tied to its funding costs. If an issuer has to buy the loan out of an MBS to modify its loan, the interest rate offered to the borrower will increase by the same amount the issuer’s funding costs increased.
If the issuer is Fannie Mae or Freddie Mac, the GSEs hold the securities on their balance sheet and fund them with their debt. The borrower is modified into a loan with the original interest rate (the rate on the modified loan is the lower of the original rate or the new rate). The original rate on the mortgage may be lower than the rate on the debt, but the GSEs can easily bear this cost.
If the organization is an issuer of Ginnie Mae–guaranteed MBS, a lower mortgage rate than debt rate is a problem for them and the borrower. When an issuer cannot afford to buy the loan, it doesn’t have an effective loss mitigation strategy to offer the borrower, and the borrower is faced with either foreclosure or sale of their home to meet their mortgage obligation.
What higher rates mean for the MBS market
In the latter scenario, when issuers buy a loan out of the pool, they lose the funding from the MBS and must fund the mortgage at their cost of funds—which in today’s market is probably substantially greater than the original note rate. After the modification, the mortgage can be repooled into a new MBS at a higher interest rate, which takes it off the issuer’s balance sheet. But the borrower will receive a modification in which they are paying a higher interest rate, and the higher mortgage payment will probably lead to the borrower losing their home.
The approximate doubling of interest rates in the MBS market has created a situation in which Ginnie Mae issuers cannot afford to buy loans out of MBS pools and lose their low-cost funding, and struggling borrowers cannot afford a proportionally higher interest rate.
The challenge the industry faces now is determining how a mortgage can be modified to a payment the borrower can afford without requiring the issuer to buy the loan out of the MBS and lose its attractive funding costs.
A three-step loss mitigation waterfall
Typically, the solution to help a borrower stay in their home and avoid foreclosure was to add the delinquent payments to the loan amount, extend the term, and move the interest rate on the mortgage to the current market. But because today’s rates are rising, moving interest rates to the current market likely wouldn’t help maintain borrower stability.
Instead, loan guarantors should consider adopting the following waterfall for loans that would not require the buyout of the mortgage from the MBS pool or the loan’s note rate to be increased.
- Determine whether the borrower can afford a payment that would repay the servicer, in 12 monthly payments, the delinquent payments plus their monthly mortgage payments. Creating balloon payments at the end of the loan should be minimized because loan guarantors have limits on how much can be added to the end of the loan over the life of the loan. The capacity to create balloon payments for future borrower hardships needs to be conserved.
- If the borrower can’t afford the additional payment to reimburse the servicer for delinquent payments, the loan guarantor should allow for the delinquent payments to be added as a balloon payment to the end of the loan. The borrower should only be required to make their original mortgage payment.
- If the borrower can’t afford their original mortgage payment, the guarantor should allow the servicer to add the delinquent payments to the end of the loan and defer enough principal to allow an affordable mortgage payment to be created by reamortization of the loan over the remaining term of the mortgage.
The following table shows that by maintaining the original mortgage note rate, the servicer can offer substantial payment relief without having to defer prohibitively high amounts of principal. If a loan remains in the pool, a $28,162 deferral of principal is required to reduce the borrower’s monthly payment by $103, or 9.9 percent. If the loan is bought out of the pool, a $90,662 deferral of principal is required to obtain the same relief for borrowers. A principal deferral of $90,662 is not possible because loan guarantors limit the size of deferral to 30 percent of the loan amount, or, in my example, $75,000.
Implementing step 3 of the waterfall would require Ginnie Mae to allow a loan to be amortized within a pool. If it wants to do this, Ginnie Mae should quickly change its policy. Doing so could create a tool servicers could use to help borrowers stay in their homes.
The first rising-interest-rate environment in 40 years requires creative solutions. The mortgage industry cannot expect falling interest rates to help borrowers avoid losing their homes. The Federal Reserve dropped interest rates to essentially zero during the pandemic. A zero-interest-rate environment crates a situation where interest rates can only go up, and they have increased substantially. The industry must develop tools that will allow borrowers who have taken on mortgage debt since the Great Recession to be successful homeowners through tough economic times. The waterfall that has been proposed will be key to helping borrowers be successful homeowners through all economic cycles.