A Rumson, N.J., company is giving underwater borrowers a reason not to walk away from their homes, a move that could help prevent further deterioration in the value of a sizable chunk of the problem loans and properties still bogging down the market.
The company, Loan Value Group, has an incentive-based patent-pending concept and automation that could help address a problem posed by what studies show are roughly more than 10 million homes in the United States that have substantial negative equity. This affects almost $2 trillion of mortgage debt, according to LVG.
Data on the percentage of all defaults overall that have been “strategic” vary from about 18% to 25%, depending on the study. However, “this number changes amount according to the LTV of the loan,” said Alex Edmans, an assistant professor of finance at Wharton and an academic advisor to Loan Value Group. He cites one study by European University Institute professor Luigi Guiso, Northwestern University professor Paola Sapienza and University of Chicago professor Luigi Zingales that indicates mortgages with loan-to-value ratios around 120% start to become more prone to strategic default. Mr. Edmans also noted that a Federal Reserve study found a 50% likelihood of default when LTVs were as high as 150%.
LVG may have a “snapshot” of data on how effective its program is within a month, according to Frank Pallotta, executive vice president and managing partner at LVG. It may also release the name of the client testing it, which is said to be a major multibillion-dollar mortgage market participant.
Customers can private-label the program, which would be used in situations where high LTVs made it compelling for certain borrowers to stop making payments and walk away from their homes even though those borrowers might have the funds available to pay. The Responsible Homeowner Reward program is designed to realign borrower incentives so that such borrowers will be encouraged to pay off their loans instead.
Through RHR, a certain amount of incentive funds are set aside separate from the unchanged existing loan. These funds accumulate every month a borrower makes a scheduled payment for a period such as five years, regardless of home price direction. The borrowers would lose all funds and accrued value if they were 30 days late on a payment in any 12-month period. Homeowners that meet the program’s requirements for timely payments receive the funds when the loan is paid off. Some other options for the incentive funds have been discussed such as using them to pay down the outstanding balance of a refinance loan.
Mortgage risk holders ultimately decide the size of the payment to the borrower but can base it on a behavioral model LVG offers. The model provides a range based on factors that include negative equity, income and geography, Mr. Pallotta said. The company offers as part of the service other additional information about borrowers on a regular basis that may be helpful to clients, Mr. Pallotta said. Servicers, who are already largely overburdened and have their roles constrained by contracts, don’t have to take on responsibility for the RHR program, which LVG and its operational partner take care of. They may benefit from it, though, Mr. Pallotta said.
RHR also can be used in conjunction with other programs that address “affordability” default, where the borrower does not have the funds to pay an existing loan and may need a modification.
The distinction between affordability and strategic defaults is key when sizing up how big the “strategic default” issue is, according to Alan Paylor, president and chief executive officer of REO Leasing Solutions LLC, Houston. When default is strategic, or “voluntary,” then “incentives start to matter,” Mr. Edmans said.
Mr. Pallotta said he believes mortgage risk holders need to focus more on default that is “strategic” rather than due to affordability concerns, something Mr. Edmans indicates represents a departure from traditional thinking for the industry.
“They’re using an affordability platform to address a negative equity crisis,” Mr. Pallotta said. “If there’s too much negative equity borrowers are going to default, regardless of income and mortgage assets. I don’t think the owners of mortgage risk have their eye enough on the ball as far as negative equity.”
RHR may allow lenders and other parties to avoid other types of more costly loan remediation efforts such as reduction of principal in cases where strategic default is the real concern, he said.
Because RHR offers incentive payments to the borrower that are totally separate from the loan, it does not affect, for example, second liens or accounting for the mortgages. It aims to better align the incentives for the parties with a stake in the loans. Owners of mortgage risk can split what Mr. Pallotta said is a relatively low cost for the service. He said the ongoing cost for administering RHR is roughly less than 5 basis points of coupon annually. The present value cost to the provider for the incentive itself could be as little as 3-6 points of principal on a $200,000 mortgage with a 135%-145% LTV.