John Adams Money 99 - Obama Plan Uses Carrot and Stick to Encourage Lender Participation

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Obama Plan Uses Carrot and Stick to Encourage Lender Participation - 2009-03-15

Last week we talked about the apparent winners and losers in the Obama administration’s plan aimed at helping distressed homeowners. This week we finally got the details we’ve been waiting for - the plan details of who gets what and how lenders will be encouraged to participate.

One of the early surprises was the scope of the refinancing plan. In case you haven’t been paying attention, this part of the program is aimed at responsible homeowners who would like to refinance to today’s low interest rates but are prevented from doing so due to falling home values.

We had originally been told that only “conforming” loans would qualify for this departure from conventional “loan to value” guidelines. In other words, the benefit would only be available to borrowers whose loan balance was less than the Fannie Mae maximum loan amount of $417,000.

I was particularly pleased to see that the details of the plan allow refinancing up to a current balance of $729,750. This part of the plan makes good sense, and here’s why:

* The program is only available to owner-occupants who are current on their existing loans. Borrowers in this group are statistically least likely to default.

* The program is only available for loans which are owned or guaranteed by Fannie Mae or Freddie Mac. Since the government is already on the hook for these loans, it makes sense to make them affordable, thus slowing down the foreclosure rate.

* Applicants must be able to qualify for the terms of the new, lower interest rate loan, and prove enough income so that the new loan is affordable and sustainable.

Unlike the modification plan, this refinancing is not temporary. Therefore it’s important that the borrower be able to afford their payments both now and in the future.

* Under a typical refinancing, the maximum loan is 80 percent of the home’s current appraised value. That has been the sticking point for many of these borrowers.

But under this program, the loan can go as high as 105 percent of the appraised value of the property. This change is a key to the program. It reflects the realization that dropping home values in a neighborhood don’t make a borrower less likely to pay on time.

For borrowers in Atlanta, the increase in maximum loan amount from $417,000 to $729,750 means that many more creditworthy borrowers will now be able to refinance and lower their monthly payments significantly.

While I am aware that there are many neighborhoods in metro Atlanta with an average loan amount in excess of these numbers, those are the exception - not the rule.

The refinancing portion of the administration plan can only help the current housing slowdown in the Atlanta area.

The second, and perhaps more ambitious, part of the president’s plan revolves around enticing lenders to voluntarily modify existing loans for homeowners who are in imminent danger of losing their home.

Under this plan, borrowers would see their interest rates drop to as low as 2 percent, in an effort to make their total housing expense fall under a 31% of gross monthly income cap.

When this plan was announced last week, I wondered what would happen to those borrowers for whom the 2 percent loan was still above the 31 percent threshold. This week we found out.

In a bold move, the newly detailed proposal will allow lenders to extend the loan term to as much as 40 years, or, if necessary, even accept principal payments without interest. This departure from traditional repayment guidelines is nothing short of remarkable, and shows the extent to which the plan hopes to provide relief.

A final feature of the plan was made clear this week, and it is the incentives that lenders may receive for voluntarily participating in the modifications.

It now turns out that lenders can receive as much as $6,000 in direct incentive payments if a loan is modified and the borrower stays on track for at least three years. In addition, there will be additional insurance payments to holders of modified loans linked to declines in local home prices.

The amount of those payments is still unclear, as it may relate to how many lenders choose to participate in the modification program.

And what happens to lenders who simply refuse to refinance or modify a borrowers loan under the president’s plan?

At this moment, it looks like Congress is set to allow bankruptcy judges the ability to modify loan terms and balances when they see fit. Such unprecedented powers strike fear in the heart of lenders everywhere.

What good is a loan when a judge can arbitrarily lower the balance, lower the interest rate, or even both?

My guess is that most lenders will jump on the “stability and affordability” bandwagon and take their medicine as quickly as possible. The sooner this crisis passes, the sooner lenders can get back to the business of counting their profits - that is, if they ever have profits again.

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