FHA Tries to Revive Underwater Homeowners

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The Federal Housing Authority will begin a new program to encourage principal write-downs of underwater mortgages on Tuesday. It would allow some borrowers whose house is worth less than their mortgage to refinance with a new balance of less than the home's value. Principal reductions have been touted as the savior of the foreclosure crisis. But will this new plan work?

First, it won't be easy for borrowers to qualify for the program. The following criteria must be met, according to the FHA (.pdf):

1. The homeowner must be in a negative equity position;
2. The homeowner must be current on the existing mortgage to be refinanced;
3. The homeowner must occupy the subject property (1-4 units) as their primary residence;
4. The homeowner must qualify for the new loan under standard FHA underwriting
requirements and possess a "FICO based" decision credit score greater than or equal to 500;
5. The existing loan to be refinanced must not be a FHA-insured loan;
6. The existing first lien holder must write off at least 10 percent of the unpaid principal balance;
7. The refinanced FHA-insured first mortgage must have a loan-to-value ratio of no more than 97.75 percent;
8. Non-extinguished existing subordinate mortgages must be re-subordinated and the new loan may not have a combined loan-to-value ratio greater than 115 percent;
9. For loans that receive a "refer" risk classification from TOTAL Mortgage Scorecard (TOTAL) and/or are manually underwritten, the homeowner's total monthly mortgage payment, including the first and any subordinate mortgage(s), cannot be greater than 31 percent of gross monthly income and total debt, including all recurring debts, cannot be greater than 50 percent of gross monthly income;
10. FHA mortgagees are not permitted to use premium pricing to pay off existing debt obligations to qualify the borrower for the new loan;
11. FHA mortgagees are not permitted to make mortgage payments on behalf of the borrowers or otherwise bring the existing loan current to make it eligible for FHA insurance; and
12. The existing loan to be refinanced may not have been brought current by the existing first lien holder, except through an acceptable permanent loan modification as described below.

Several of those criteria immediately eliminate many struggling homeowners. They can't be delinquent or have poor credit scores. So essentially, the measure is in place mostly to prevent more homeowners who can afford their underwater mortgage from giving in to strategic default and walking away.

The program will also likely suffer from a common mortgage modification problem which stems from second liens. Although second lien servicers and investors will get carrots through the process, the incentives may not be large enough for these parties to give up their right to their debt, particularly since these are paying borrowers. Their claim must be subordinated and probably reduced to obtain the 115 combined loan-to-value ratio.

The real trick will be getting the first-lien investors to go along. They must approve these modifications. And their acquiescence means accepting large principal losses -- of at least 10%. This seems like a particularly unlikely choice, considering that the borrowers in question are paying, and not a threat to foreclosure due to financial distress. These investors would have to, for some reason, believe that the borrowers will strategically default. Otherwise, the investors are better off just letting the homeowners continue to pay for a mortgage worth more than their home.

And even in the cases where investors do sense strategic default, they will have to believe that the resale after foreclosure will be worth less than 97.75% of the current appraised value, plus any additional small cash incentive the FHA might offer. If they do, then accepting the terms is a no-brainer: now the FHA is insuring the loan, so there's no chance of a loss beyond that.

From both the borrower and investor standpoint, making these principal reductions happen will be a challenge. So it isn't likely that we'll see widespread modifications through the new initiative. But some lucky borrowers may find some relief.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.
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