New mortgage design would minimize home foreclosures

Jan 19, 2011

With mortgage loan defaults on the rise yet again, two mortgage researchers are proposing a new type of mortgage contract that automatically resets the balance and the monthly payment based on the mortgaged home's market value.

Brent Ambrose, Smeal Professor of Real Estate and director of the Institute for Real Estate Studies at the Penn State Smeal College of Business, and Richard Buttimer, a professor in the Belk College of Business at the University of North Carolina at Charlotte, call their new mortgage contract the "adjustable balance mortgage" and contend that it reduces the economic incentive to default while costing about the same as a typical fixed-rate mortgage. Under real-world conditions, including the presence of unrecoverable default transaction costs to the lender, this new mortgage contract is better for both lenders and borrowers.

"The threat of foreclosure is not sufficient to prevent widespread default when house prices fall significantly," Ambrose and Buttimer write. "Our new mortgage automatically resets the principle balance at various dates to the minimum of the originally scheduled balance or the value of the house, reducing the borrower's incentive to default if the house value declines."

At origination, the adjustable balance mortgage resembles a fixed-rate mortgage -- it has a fixed contract rate and is fully amortizing. From that point on, at fixed, pre-set intervals, the value of the house would be determined based on changes to a local house price index. If the house value is found to be lower than the originally scheduled balance for that date, the loan balance is set equal to the house value, and the monthly payment is recalculated based on this new value. If the house retains its initial value or increases in value, then the loan balance and payments remain unchanged, just as in a standard fixed-rate mortgage.

For example, if a homeowner was found to owe more than the current market value of her home at one of the predetermined quarterly adjustment dates, then her balance would reset to the current market value and her monthly payment would be lowered as a result. At the next reset interval, if the market had recovered and the house was now worth more than what the homeowner owes, the mortgage balance reverts back to the originally scheduled balance, resulting in a higher monthly payment but one that does not exceed the payment specified at origination.

This new arrangement results in a sharing of the home-price risk between lender and borrower while providing an economic incentive for the borrower to maintain the property even during significant price declines.

"Before the loan balance is reset, the borrower will have lost whatever initial equity they had in the property, plus any equity that they would have built-up through the amortization process," the researchers write. "Should the house price fall below the balance triggering a reset, and the house value then subsequently rises, the lender recovers their lost value first. In addition, if the house value rises above the originally scheduled balance on a reset date, then the owner begins to recover their equity as well."

Through financial modeling and analysis, Ambrose and Buttimer determine that the adjustable balance mortgage would have a lower contract rate than the standard fixed-rate mortgage when the loan-to-value ratio is above 80 percent. Further, they find that their new mortgage provides lenders with an incentive to use a derivative contract to hedge against the risk of home price declines.

According to Ambrose, analysis of this new mortgage provides insight into why the federal loan modification programs are not as successful as expected. The modification plans presented by the U.S. Treasury, Federal Reserve, and FDIC focus strictly on borrower payment-to-income ratios, and, as a result, do not remove the incentive to default for long. In fact, the Office of the Comptroller of the Currency has reported that up to 37 percent of modified mortgages were 60 days into a second default within six months of the modification.

"The only way to truly reduce the default probability is to either reset the balance to a LTV that is lower than 100 percent, probably around 80 percent, or have frequent, predictable balance resets," Ambrose says. "The key implication is that the programs rolled out by U.S. regulatory authorities will not significantly reduce defaults unless house prices rapidly stabilize or go up, independent of issues such as moral hazard."

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More information: "The Adjustable Balance Mortgage: Reducing the Value of the Put" is scheduled for publication in a forthcoming issue of Real Estate Economics.

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geokstr
1 / 5 (3) Jan 19, 2011
Wow, this looks like a really good deal - for the borrower. The lender gets to share the full risk with the borrower if the price goes down, but only the borrower benefits if the price goes up past the original balance.

I have a better idea. How about the federal government gets it stinking face out of the real estate market, and allows lenders to go back to time tested business practices of making, like, you know, sound loans to people who might actually be likely to pay them back?

For decades, and starting in the mid-90's it got out of hand, the feds demanded that loans be made without down payments, no credit or job history, and food stamps counting as income. Then they mandated that Fannie/Freddie start buying hundreds of billions of $ of these bad loans. It doesn't take a Nostradamus to see that this could only end badly, with a huge faux increase in real estate "values" brought on by artificially induced demand to give the poor the right their own McMansion. More Prog stuff.
PinkElephant
4 / 5 (4) Jan 20, 2011
More Prog stuff.
Eh... wasn't it George Bush Jr. (in conjunction with Alan Greenspan) who so energetically and successfully pushed the "ownership society"? (As a way to blow a new bubble, replacing the tech bubble that popped in 2000?) And wasn't it those two (again) who so ardently advocated deregulation of financial markets, investment banks, derivatives, mortgage lending, and just about everything else?

Enron in, Enron out.
dandy
5 / 5 (2) Jan 20, 2011
yes why dont people with high rates get a rebate if they pay on time .like if you pay 1 year no trouble get a better rate the next one. why should people with low scores good enough to loan to be penalized because you thought they might not!
ryggesogn2
1.8 / 5 (5) Jan 20, 2011
The CRA was started under Carter and expanded under Clinton.
OCT 1997 Wachovia press release:
" First Union Capital Markets Corp. and Bear, Stearns & Co. Inc. have priced a $384.6 million offering of securities backed by Community Reinvestment Act (CRA) loans - marking the industry's first public securitization of CRA loans."
"The $384.6 million in senior certificates are guaranteed by Freddie Mac and have an implied "AAA" rating. "
https:/www.wachovia.com/foundation/v/index.jsp?vgnextoid=dde12e3d3471f110VgnVCM200000627d6fa2RCRD&vgnextfmt=default&key_guid=52e84a86591eb110VgnVCM100000ca0d1872RCRD
The rest is history.
ryggesogn2
1 / 5 (3) Jan 20, 2011
Of course property taxes won't drop if the home value drops.
Skeptic_Heretic
3.8 / 5 (4) Jan 21, 2011
The CRA didn't cause a problem. The disappearance of community banks, deregulation namely the repeal of G-S, and securitization allowed for this scam to take place. The majority of these problems can be evenly split between Clinton and Bush Sr. Bush Jr. just sped up the process by getting us involved in war and covering up the rapid loss of manufacturing jobs due to globalization.

To his credit, he did try to fix the system, he simply got very, very bad advice from Daddy's friends and started doing the right thing far too late.
ryggesogn2
1.7 / 5 (6) Jan 21, 2011
The CRA didn't cause a problem.

That was the motivation to securitize loans.
CRA was the excuse FDIC used to punish a MA bank for not making enough bad loans.
Skeptic_Heretic
3.7 / 5 (3) Jan 21, 2011
The CRA didn't cause a problem.

That was the motivation to securitize loans.
No, the move to securitization of CRA assets didn't occur until 1997. Securitization of mortgage pools was a mainstay practice of the banking industry as early as 72 and was initially adopted in 1970. Removal of G-S allowed these securities to be traded off to institutions that prior would not be legally allowed to obtain these assets for restructure.
CRA was the excuse FDIC used to punish a MA bank for not making enough bad loans.
No. The CRA was a favorable act for community banks. The large banks that didn't know who they were loaning money to abused the CRA.

The core cause of the whole bubble and collapse was deregulation, followed by corporate consolidation into organizations that were "too big to fail". Community banks that made bad loans went under. Commercial banks, who weren't beholden to the CRA initially, had no problems as their loan base wasn't individuals.
ryggesogn2
1.8 / 5 (5) Jan 21, 2011
"the FDIC slapped East Bridgewater Savings with a rare “needs to improve” rating after evaluating the bank under the Community Reinvestment Act…"
"n the eyes of regulators, East Bridgewater Savings looks stingy. Its net loans and leases equaled 21 percent of assets. That compared with 72 percent among 385 savings banks across the country with assets between $100 million and $300 million.

“We want to make loans,” Petrucelli said. “But we also wanted to avoid the next blow up.” …"
http:/sweetness-light.com/archive/fdic-hits-bank-not-enough-bad-loans

securitization of CRA assets didn't occur until 1997.

That's what I said in a previous post. Wachovia securitized mortgages to meet CRA requirements in OCT 1997.
Skeptic_Heretic
5 / 5 (1) Jan 21, 2011
And what penalty does that rating carry with it?

I'm waiting for you to show how the FDIC actually forced banks to do anything.
ryggesogn2
1 / 5 (3) Jan 21, 2011
And what penalty does that rating carry with it?

I'm waiting for you to show how the FDIC actually forced banks to do anything.

FDIC said they "needed to improve".
Skeptic_Heretic
5 / 5 (1) Jan 21, 2011
And what penalty does that rating carry with it?

I'm waiting for you to show how the FDIC actually forced banks to do anything.

FDIC said they "needed to improve".

I've told you that you need to pay attention and read more thoroughly, as so far, you haven't done either.

Saying something doesn't make other people or companies change. Welcome to reality.
ryggesogn2
1.8 / 5 (5) Jan 21, 2011
Saying something doesn't make other people or companies change.

When it's a govt agency that has power over your business, then you pay attention to what they have to say.

BTW, if the new mortgage is such a great idea, why don't the professors proposing the idea start their own company and prove their ideas?

Skeptic_Heretic
3 / 5 (2) Jan 21, 2011
Saying something doesn't make other people or companies change.

When it's a govt agency that has power over your business, then you pay attention to what they have to say.
You mean like BP did? Or Microsoft? Or any one of your other free market hero companies?
BTW, if the new mortgage is such a great idea, why don't the professors proposing the idea start their own company and prove their ideas?
Because there are laws that dictate the structure of mortgages.
ryggesogn2
1.7 / 5 (6) Jan 21, 2011
You mean like BP did? Or Microsoft? Or any one of your other free market hero companies?

What does that mean?
FDIC can take over a bank.
It is much more difficult for any govt regulatory agency to take over BP or MS, fortunately.
But BHO has effectively shut down oil drilling in the Gulf. Drilling rigs respond by relocating to more profitable waters. THAT'S PROGRESS?
Skeptic_Heretic
3 / 5 (2) Jan 21, 2011
FDIC can take over a bank.
Not for CRA compliance.

As I said, tell us what the rammifications of non-compliance are, you know, aside from "the FDIC rates us poorly".
ryggesogn2
1 / 5 (3) Jan 21, 2011
FDIC can take over a bank.
Not for CRA compliance.

As I said, tell us what the rammifications of non-compliance are, you know, aside from "the FDIC rates us poorly".

If there is no consequence, why bother with the rating?
Skeptic_Heretic
5 / 5 (1) Jan 21, 2011
If there is no consequence, why bother with the rating?
If there is a consequence, state it, if there isn't, recant your statement.
Cin5456
2.5 / 5 (4) Jan 21, 2011
Food for thought:
The company that rated the oil and mortgage derivatives was and is Standard and Poor, a division of McGraw Hill,
McGraw Hill also owns Platts:

Platts, a division of The McGraw-Hill Companies (NYSE: MHP), is a leading global provider of energy and metals information.
on the Board of directors of ExxonMobil: Joaquin Pelayo, Chairman of the Board and President, McGraw Hill.
The company that rated the mortgages derivatives market are the same people who rated the oil derivatives market.
Recall that while the mortgage market went bust, so did the oil market.

The stock market's performance is directly related to the oil market's success. As long as big oil is doing well the stock market goes up. The first sign of oil taking a dive was the start of the mortgage market bus.

Big Oil has it's hand in everything.
ryggesogn2
1.7 / 5 (6) Jan 21, 2011
Food for thought:
The company that rated the oil and mortgage derivatives was and is Standard and Poor, a division of McGraw Hill,
McGraw Hill also owns Platts:

Platts, a division of The McGraw-Hill Companies (NYSE: MHP), is a leading global provider of energy and metals information.
on the Board of directors of ExxonMobil: Joaquin Pelayo, Chairman of the Board and President, McGraw Hill.
The company that rated the mortgages derivatives market are the same people who rated the oil derivatives market.
Recall that while the mortgage market went bust, so did the oil market.

The stock market's performance is directly related to the oil market's success. As long as big oil is doing well the stock market goes up. The first sign of oil taking a dive was the start of the mortgage market bus.

Big Oil has it's hand in everything.

Caveat Emptor.
Party
not rated yet Jan 23, 2011
fdsadfsadfsafsdafdsaf
Party
not rated yet Jan 23, 2011
Here is similar story
With mortgage loan defaults on the rise yet again, two mortgage researchers are proposing a new type of mortgage contract that automatically resets the balance and the monthly payment based on the mortgaged home's market value.