On April 24, 2013 the Office of the Special Inspector General for the Troubled Asset Relief Program (SIGTARP) issued their Quarterly Report to Congress. Included in the report was a summary of the TARP homeowner relief programs, including the Home Affordable Modification Program (HAMP). The summary focused on alarmingly high re-default rates on HAMP Modifications, which, in a world with a very limited sample size, especially as it relates to modifications made at the individual credit union level, provides valuable information.
The report data indicates that there are currently 862,279 Active HAMP Modifications and approximately 312,000 that re-defaulted. Assuming a menial number of HAMP Mods paid off / matured, that means approximately 1.2 million Mods have been made and that approximately 26.0% of these re-defaulted. Not a terribly high number if you consider that the percent of those 1.2 million homes that would be foreclosed on absent the modification would have been much higher.
What is alarming is the increasing re-default percentage as these loans age. The HAMP program began in the third quarter of 2009. HAMP mods made in the third and fourth quarters of 2009 have re-defaulted as percentages of 46.1% and 39.1%, respectively. Re-default rates on HAMP mods made in 2010 range from 28.9% to 37.6%. Consider the fact that these modifications range from 9 quarters to 14 quarters in age. Let’s look at it from a static pool perspective:
- Q9 – 28.9%
- Q12 – 37.6% (~+2.9% per quarter)
- Q13 – 39.1% (+1.5%)
- Q14 – 46.1% (+7.0%)
So a 46.1% re-default rate over three and a half years… A lot lower than 100% default, but high nonetheless and three and a half years is still early in the game. It certainly highlights the fact that restructuring a mortgage is not an end-all be-all solution to a troubled debt.
There’s a lot more to it than that. Let’s look at the HAMP program as an example:
The basic formula for quantifiable modification program success is:
Present Value of Cash Flows WITH MODIFICATION
(Less): Present Value of Cash Flows WITHOUT MODIFICATION
(Less): Cost of Modification Administration
= Program Value Added
The above formula calculates the differences in cash flows to the credit union based on the credit union’s decision to modify or foreclose.
The Present Value of Cash Flows WITHOUT MODIFICATION
This can be easily estimated (although estimates may differ from actual) as Fair Value of Property Less Cost to Sell.
The other two are more tricky.
The Present Value of Cash Flows WITH MODIFICATION
This can be calculated definitively at the time of modification under the assumption that the member does not re-default. The problem is that SIGTARP is indicating many modifications will ultimately re-default. The uncertainty here is when will the borrower re-default on the loan.
Timing affects the time-value of money (Present Value Calculation). Remember, all else equal, cash proceeds received from a foreclosure now are worth more than the cash proceeds received from a foreclosure several years from now. It also affects the undiscounted cash flows. If the member continues to pay down principal prior to re-defaulting, the credit union will be able to recover more of its principal balance, thus reducing the loss.
The theoretical solution would be to estimate likelihood of default at different points in time, and calculate the expected value of the cash flows. This would be extremely difficult to do on a loan-by-loan basis, but fortunate for us, SIGTARP has given us default rates and different points in time!
Cost of Modification
Costs of Modification include Administrative Costs and Costs of the Concession. Costs of Concession can be broken out into two pieces; Forgiven Principal and Interest Rate Differential.
Interest Rate Differential is calculated as the difference between the present values of cash flows under the modified rate and the present value of cash flows using a market rate. If a member re-defaults immediately, the cost of interest rate differential is very small. If a member pays off to maturity, the cost of the interest rate differential is much greater.
Those are our variables, so let’s input the assumptions from the HAMP program:
Re-defaults occur in the 9th through 14th quarters of modification. All modifications that make it past the 14th quarter will not re-default (an aggressive assumption), 53.9% of modifications will make all payments.
Assuming the re-default rates above, a 20 year modification and 3% annual interest, approximately 5.4% of principal payments will be received on modified loans that ultimately re-default.
So, under the modified terms, approximately 59.3% of principal payments will be received, in cash.
Assuming market rate for the modified loan is 5% (again, aggressive for someone with poor credit), the Interest Rate Spread (present value difference in cash flows) is a loss of 16% if the loan does not re-default. However, there is a 46.1% change that the loan will re-default and in that case, Interest Spread Costs are lower.
Let’s just say that administrative costs are flat at 2% of principal. Here are the results and an explanation of the formulas used:
The expected loss on the modification is approximately 24.7% of principal balance. That would be an improvement over foreclosure on a loan with 125% loan to value before selling costs of 7.3%. The chart also calculates break even loan to value before selling costs. What that shows us is that a TDR with a Pre-Modification, Pre-Costs to Sell LTV lower than 112.8% would lose money regardless of TDR performance.
It can also be noted that even a modification with an expected gain could produce a loss. At the modification date, the loss on modification is equal to the cost of administration (and any forgiven principal). If the member re-defaults before repaying enough principal to cover the admin costs, the modification will operate at a loss.
In an organization owned by its members, to give to one member (in the form of incurring a loss) is to take from another member. Based on that idea, if the loss on the modification is less than or equal to the loss on the foreclosure, it would be practical to issue the modification. However, if the loss on the modification is greater than the loss on the foreclosure, it would be unjust to your other members to make the modification.
Credit Unions have the advantage of having a much more personal relationship with their members, but it is important to remember that because each member is unique, it is important to thoroughly review member situations and, based on the situation, either tailor your modifications to create a sustainable stream of payments for the member, or foreclose and move on.
-Dan Price, CPA
Twenty Twenty Analytics Blogger