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Hardly a news cycle passes without another bank or lender announcing a loan modification initiative. Yet, in spite of these efforts, the failure rate of loan modifications exceeds 50%.  With the number of foreclosures increasing nationwide, a worsening economy, and growing unemployment, the pressure is building for lenders to better manage the mortgage crisis.  The FDIC provides a model to address the loan modification process but some financial experts say that it does not accommodate rapidly changing market dynamics, nor is it robust enough to test assumptions and analyze options lenders should consider in loan modifications.

The FDIC model estimates an individual loan’s modification terms and options under a single set of assumptions.  By reengineering the model with Quantrix Modeler, the deficiencies of the Excel-based model become apparent.  With Quantrix, lenders can test the sensitivity of two important assumptions: upper HTI limit and estimated house price appreciation (depreciation). 

•    HTI – The FDIC model assumes a maximum housing expense to income (HTI) ratio of 38% and is structured in such a way that modifications for borrowers with lower income will tend to reach 38%.  This level is in contrast to a ratio, equivalent in definition, of 29% recommended by the FHA.  Modifications that fail and result in redefault pose a serious issue to lenders. A primary driver for redefault may be an untenable HTI level for the borrower.  Recent research by LPS Applied Analytics suggests that payment reduction is the crucial factor in reducing redefault risk – an intuitive observation given the stress to cash flow for homeowners these days.  Because unemployment is increasing and incomes are decreasing, it is now even more important for lenders to test the sensitivity of the model with two alternative HTI scenarios: 29% and 25%. 

•    HPA – The potential loss associated with foreclosure is heavily impacted by the housing price appreciation assumption.  With little in the way of history to predict HPA in the current economic environment, it is important to understand the influence of variance from expected HPA levels on the loan modification decision model. 

The table below represents an extract from the Quantrix model that illustrates the results for three HTI cases: the original FDIC with maximum of 38%, 29% as recommended by the FHA, and 25%.  For the purposes of this example, the redefault rate has been set at 50%, 30%, and 20% respectively for the three scenarios.  The table illustrates that all three cases offer modifications which are favorable relative to foreclosure.  While the payment in the second scenario is roughly 27% less than the payment in the first scenario, the potential benefit of the modification over foreclosure is actually slightly better. 

This outcome is even more pronounced if one takes a more conservative view on HPA:

The table also highlights the homeowner’s equity position in the property based on the modified loan, current value, and expected HPA.  Under the base FDIC case, the homeowner has an equity position of negative 21%.  If home price appreciation ultimately returns to long-term growth levels, it may take ten or more years for the homeowner to reach a positive equity position in the property.  When evaluating the risk of redefault, it is important to remember that there are two parties to a modification agreement, and the one sitting across from the lender may find foreclosure to be the better of two bad choices.

This expanded model is not meant to define specific levels for key inputs/assumptions such as HTI, HPA, and redefault rate.  There are tools and algorithms to assist in this process, and the model can be expanded to incorporate these characteristics for specific loans and loan pools.  However, it does highlight the relationships and dynamics inherent in the model and relates them to market conditions.  A multidimensional modeling approach such as this provides decision-makers with the ability to make more informed choices and the flexibility to quickly adapt.  Implemented properly, the model scales to evaluate large pools of loans.  Quantrix works with lenders to customize the model to suit their requirements.

To view a simplified version of the online Mortgage Modfication model, please click here.  To inquire about purchasing the the Mortgage Revaluation Model for your lending organization, please contact Quantrix. 

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