Two weeks ago, the U.S. Treasury released additional details (link opens .pdf) about the homeowner bailout, or in Washington-speak the "Making Home Affordable" program. Part of those details included some new ways for homeowners to avoid foreclosure. I thought the far more fascinating part, however, was the so-called "Home Price Decline Protection Incentives" (HPDP). It's the most interesting part of the homeowner bailout that you probably haven't heard about. I have been fascinated with the HPDP since the bailout was announced in February, and now we finally have some detail to dig into.
For some strange reason, virtually no one is talking about the HPDP. I haven't seen a single article on it. Here's how the new fact sheet describes it:
This initiative provides lenders additional incentives for modifications where home price declines have been most severe and lenders fear these declines may persist. These incentives will encourage servicers to undertake more modifications by assuring that incremental investor losses will be partially offset.
All of the initiatives within the homeowner bailout have attempted to stabilize the housing market. But this is the only one that provides a sort of insurance to investors if home prices continue to decline. In February I remarked that it seemed like the housing bailout included everything but the kitchen sink. I was wrong: this is the kitchen sink.
So how does it work? Investors who hold modified mortgages as assets will receive payments for 24 months if home prices decline. The Treasury hopes that this will eliminate one of the reasons servicers might not be crazy about making mortgage modifications. After all, if the homeowner re-defaults after modification, then a worse housing market means a greater loss to investors when they foreclose and sell the house. The HPDP makes up some of that loss, mitigating some of the risk stemming from further home price declines.
I find a few aspects of this program extremely perplexing. The first is that it has a $10 billion cap. How do they know if this cap has been reached? Investors receive payments for up to 24 months. What if home prices decline more than the Treasury anticipated? And what if they underestimate the number of loans that would qualify? How to they cap it at $10 billion if they've promised the protection? My guess is that they find more money somewhere else, meaning this "cap" is more of a "guide."
But I am most surprised at how these payments are distributed: whether the homeowner re-defaults or not.
Let's say you're an investor, and you hold a mortgage as an asset which a family has modified under the circumstances necessary to qualify for the program. The housing market, during the first two years, declines by 25%. You get HPDP incentive payments.
If the homeowner re-defaults, then part of the loss you incur because of the decline in the home's value is covered.
If the homeowner does not re-default, then you get to keep this money anyway.
I've read this fact sheet several times, and despite the fact that the HPDP is supposed to guard against losses due to re-default, there's no provision saying that investors only get payments under that circumstance. It's a pretty sweet deal for investors. If the homeowner re-defaults, some of their loss is covered. If not, then they get their anticipated future return, as well as the payments that would have covered part of the re-default loss.
Upon first reading this, I could not figure out why the Treasury would provide this protection even if the homeowner does not re-default. After all, you don't need the protection in a circumstance where there's nothing to be protected from.
But then it hit me: maybe the Treasury is anticipating that the mortgage held as an asset could lose value due to mark-to-market requirements. If the housing market continues to decline, so should the value of mortgage securities, as their value would take housing prices into account. By providing investors the HDDP incentive payments, you also protect against their short term loss. The hold-to-maturity value would be unaltered if the homeowner never re-defaults, but the market value would certainly take a hit if home prices decline.
This can be seen two different ways. On one hand, perhaps the Treasury has smartly anticipated that investors may be wary about market value declines in mortgage securities if home prices decrease, so the Treasury wants to provide them an incentive to offset that fear. On the other hand, this loss in mortgage securities is only real in the case of re-default, and investors get the incentive payments either way. So the Treasury might be compensating investors for losses that are never actually incurred if the mortgage securities are held to maturity.
Is the Treasury really smart or really generous to investors? Maybe they're a little of both.
We want to hear what you think about this article. Submit a letter to the editor or write to email@example.com.