An Assessment of FHA s Single-Family Mortgage Insurance Loss Mitigation Program. Final Report. Executive Summary

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1 An Assessment of FHA s Single-Family Mortgage Insurance Loss Mitigation Program Final Report Executive Summary Cambridge, MA Lexington, MA Hadley, MA Bethesda, MD Washington, DC Chicago, IL Cairo, Egypt Johannesburg, South Africa November 2000 Prepared for William J. Reeder U.S. Department of Housing and Urban Development Office of Policy Dev. and Research 451 Seventh St., SW, Room 8212 Washington, DC Abt Associates Inc. 55 Wheeler Street Cambridge, MA Prepared by Christopher Herbert Debbie Gruenstein Kimberly Burnett

2 Executive Summary Background Prior to May 1996, lenders servicing Federal Housing Administration (FHA) loans were required to either recommend that the Department of Housing and Urban Development (HUD) accept assignment of mortgage notes that had become 90 days delinquent or initiate foreclosure proceedings. Given the benefits of this approach to both servicers and borrowers, assignment was the principal form of loss mitigation for delinquent FHA loans. However, in many cases the long forbearance periods used under the assignment program created such enormous debts that borrowers were ultimately unable to resolve their delinquency and faced foreclosure. By creating much larger delinquencies, the assignment program also led to much higher losses for the insurance fund than would have been the case if foreclosure or some other resolution had been pursued earlier. In April 1996, at HUD s request, Congress terminated the assignment program and in its place authorized additional loss mitigation tools. To replace assignment, HUD initiated a comprehensive loss mitigation program that included a range of options either to help borrowers retain their homes or to dispose of their property in ways that mitigated the costs of foreclosure for both the borrower and the insurance fund. Specifically, the program provided the following five options for curing delinquencies, which are to be considered sequentially: Special Forbearance: This option entails the use of a long-term repayment plan that may provide for reduced or suspended payments when there is a reasonable likelihood that the borrower can resume normal payments. Loan Modification: A loan modification entails a permanent change in the terms of a mortgage to accommodate capitalization of the accumulated delinquency. The new monthly payment may be higher or lower than the existing payment depending on whether other loan terms can be modified to offset the higher loan balance. Borrowers who lack sufficient resources to make up the deficit or to continue to afford the current level of monthly payments are eligible. Modifications may change the term, interest rate or loan type. To modify an FHA loan, it must be purchased out of a Ginnie Mae pool and then re-pooled after being modified. Partial Claim: A partial claim provides for funds to be advanced from the insurance fund to repay the arrearage for a borrower. To be eligible for this option, a borrower must have longterm financial stability to support the mortgage debt, but lack the resources to cure the delinquency. Pre-Foreclosure Sale: In cases where the borrower is unable or unwilling to maintain ownership and the market value of the property is less than the level of debt, this option allows borrowers to sell their property and apply the proceeds to retire the debt. Any debt in excess of the sales proceeds is forgiven. This process generally is preferred by borrowers because a foreclosure generally has more serious consequences for their credit rating. By Abt Associates Inc. Executive Summary iii

3 avoiding the time and expense of a foreclosure process and a subsequent sale of the property, this approach is also likely to be more cost effective for the insurance fund. Deed-in-Lieu of Foreclosure: If a pre-foreclosure sale is not feasible because of an inability to sell the property for a sufficient return, the borrower may voluntarily deed the property to HUD to avoid foreclosure. Like a pre-foreclosure sale, the a deed-in-lieu avoids the trauma and credit consequences of a foreclosure for borrowers and should result in lower costs for the insurance fund. Perhaps the most important aspect of the program is that it returned the responsibility for managing delinquent loans to servicers. Importantly, FHA does not have to approve the use of any of these options. In order to encourage lenders to engage in loss mitigation, HUD offers incentive payments to lenders for completing each of the loss mitigation workouts. In addition to these incentives, lenders also face a variety of financial penalties for failing to engage in loss mitigation. Study Purpose and Methodology The goal of this study is to gain a systematic, empirically based understanding of the extent to which the loss mitigation program is now being utilized four years after it was initiated. The ultimate goal of the study is to make recommendations to HUD for ways in which the program can be made more effective. Among the specific issues that this study is meant to address are: How is program use best measured? Given these measures, how has use of the loss mitigation program evolved? How does the use of loss mitigation by FHA servicers compare to the use of loss mitigation on conventional loans? How effective has the loss mitigation program been in helping borrowers to maintain homeownership and reducing claims on the insurance fund? What obstacles exist either in terms of program rules or contextual factors that either restrict use of the program generally or specific tools? How well do incentive payments reimburse lenders for their expenses in running the program? Are there aspects of loss mitigation programs in use by private industry, other government agencies, or non-profit organizations that could be incorporated into HUD s loss mitigation program? How are others using technology to improve the use of loss mitigation? Of these issues, perhaps the most important for HUD are the questions regarding the effectiveness of the program in helping borrowers retain homeownership and in minimizing losses for the insurance fund. Unfortunately, there has not yet been enough experience with the program to provide reliable long-run estimates of program effectiveness. In addition, it is also likely that HUD will need to collect more information than is currently available on the circumstances prevailing at the time of default in order to provide adequate controls for isolating the impact of the program on outcomes. While this study does present preliminary estimates of the expected cost to HUD of using loss iv Executive Summary Abt Associates Inc.

4 mitigation, this issue requires further study before any conclusions can be drawn about the effectiveness of the specific tools or the program generally. Two analytic approaches were used in this study. One approach relied on a quantitative analysis of administrative data maintained by HUD on the incidence of defaults and the filing of claims for loss mitigation incentive payments and insurance claims. The second analytic approach entailed conducting interviews with HUD staff, servicers, housing counselors, state government and nonprofit organizations, and representatives of Fannie Mae, Freddie Mac, and the Mortgage Bankers Association. In addition to these interviews, servicing guides and other program materials were reviewed for Fannie Mae, Freddie Mac, private mortgage insurers, and state government and nonprofit organizations to gather information on their approaches to loss mitigation. Analysis of Loss Mitigation Use After a slow start, loss mitigation claims grew rapidly during 1998 and early Quarterly trends for the last half of fiscal year 1999 show that the level of loss mitigation activity has leveled off. Growth trends have not, however, been uniform across the five loss mitigation tools. Consistent with expectations, pre-foreclosure sales and deeds-in-lieu were initially the most common approaches used, since servicers had been introduced to these tools in 1994, two years prior to the official start of the Loss Mitigation Program. Over time, however, use of the three retention tools (i.e., special forbearance, loan modification, and partial claim) has grown, while the volumes of pre-foreclosure sales and deed-in-lieu have declined. Since the program was launched, repayment and informal forbearance plans have also increased, indicating that the introduction of loss mitigation may also be encouraging lenders to make greater use of these approaches to solve delinquencies before loss mitigation tools are needed. The rate of loss mitigation usage has also increased. Initially less than 2 percent of all default episodes received loss mitigation treatment, but by 1999 this share had climbed to over 5 percent. However, measuring the rate of loss mitigation use as a share of default episodes is problematic since the rate cannot truly be estimated until all default episodes from a given period have resolved which can take years. Therefore, the most common measure of loss mitigation utilization in the mortgage industry is the workout ratio, which is equal to the number of loss mitigation workouts divided by the sum of loss mitigation workouts and foreclosures. When assignments are included as workouts, the workout ratio for FHA loans shows a precipitous decline from the end of assignment program through the first half of 1998 (see Exhibit ES-1). This decline in the workout ratio indicates that with the end of assignment, borrowers initially had fewer options for workouts. However, beginning in 1998, servicers use of loss mitigation grew rapidly. By 1999, the workout ratio had tapered off at roughly at same level as prior to end of the assignment program. While future trends in program use are not clear, at this point the loss mitigation program is producing similar levels of workouts as under the assignment program. Nonetheless, FHA borrowers do not benefit from workouts at nearly the same rate as conventional borrowers at least as measured by the workout ratio. The aggregate workout ratio for FHA lenders in 1999 was 27 percent, compared to 51 percent for Fannie Mae. Furthermore, 44 percent of FHA loans are serviced by lenders with workout ratios of less than 22 percent, compared to only 4 percent Abt Associates Inc. Executive Summary v

5 of Freddie Mac loans, and 36 percent of FHA loans are serviced by lenders with a workout ratio over 30, compared to 78 percent of Freddie Mac loans. While a lower workout ratio might be expected for the FHA portfolio given the lower incomes and wealth of FHA borrowers, it is unlikely that such a large disparity can be attributed solely to differences in borrower characteristics. Exhibit ES-1 FHA Workout Ratio, by Quarter q1 1995q2 1995q3 1995q4 1996q1 1996q2 1996q3 1996q4 1997q1 1997q2 1997q3 1997q4 1998q1 1998q2 1998q3 1998q4 1999q1 1999q2 1999q3 1999q4 One of the most striking aspects of the loss mitigation program is that there is very little consistency in how lenders are using the program. As would be expected, loss mitigation utilization, as measured by the workout ratio, varies to some extent with borrower, loan, and property characteristics. However, there is much greater variation in loss mitigation usage across servicers than there is by borrower, loan or property characteristics. There is a some relationship between servicer size and the workout ratio, with larger servicers more likely to be making greater use of loss mitigation. Larger servicers also had more of a tendency to concentrate loss mitigation efforts in retention tools than their smaller counterparts. However, even within lender size classes there is great variation in both the overall workout ratio and the shares of loss mitigation tools used. Analysis of Program Effectiveness It is still too early to assess the degree to which the loss mitigation program has been effective in helping borrowers retain ownership since it can take several years for a delinquency to be completely resolved. For example, of loans that experienced default during 1998, 26 percent were either still in default or had re-defaulted by the end of Up to now, loans benefiting from loss mitigation retention options have had a lower claim rate than loans that did not receive loss mitigation intervention. Twenty-seven percent of loans that did not receive any of the three loss mitigation retention tools have ended in a pre-foreclosure sale, a deed-in-lieu, or a foreclosure claim. In contrast, those loans receiving special forbearance have had a claim rate of 7 percent and those vi Executive Summary Abt Associates Inc.

6 receiving loan modification or partial claim have had a 2 percent claim rate. However, more time is needed to assess the effectiveness of the program, since a particularly high percentage of loans receiving each of the loss mitigation options was still in default at the time of our data collection. If a significant share of these defaulted loans eventually end in a claim, the claim rates for loans receiving loss mitigation may not differ much from the claim rates of loans not receiving any loss mitigation. In addition, in order to isolate the impact of the program on outcomes, additional data will need to be collected to provide sufficient statistical controls for differences in the characteristics of loans and borrowers benefiting from loss mitigation. Using the experience to date with claim rates on loans using the loss mitigation retention options and the average net costs to HUD of loans that have gone through claim and property disposition, we have projected estimated cost ranges to the FHA insurance fund of the use of these tools. Even under pessimistic assumptions about potential claim rates, the expected cost of the three retention tools is lower than for loans not receiving any loss mitigation. In addition, the average cost of a preforeclosure sale is cheaper than the average net cost of a foreclosure. However, the average cost of deeds-in-lieu is actually higher than the average cost of foreclosure, though these higher costs are likely due to the characteristics of properties that end in deed-in-lieu. However, it is important to note that these findings concerning the estimated costs to HUD of loss mitigation are extremely preliminary and crude. The lower cost to HUD of the loss mitigation retention options is largely due to the fact that average net costs for loans with special forbearance, loan modification, and partial claim are estimated to be much lower than claims for loans without loss mitigation treatment. But it is quite likely there is a substantial bias in these estimates of the cost of claims since the only loans that received loss mitigation treatment and then both foreclosed quickly and went through property disposition quickly will have net cost information available. In order to provide precise estimates of the effectiveness of the loss mitigation program, more experience is needed to determine the claim rate and the net costs to HUD. In addition, multivariate analysis is needed to control adequately for borrower, loan and property characteristics to isolate program impacts. Better information than is currently available will be needed for this analysis. Findings from Interviews with Servicers and Housing Counselors Servicers have established loss mitigation staff that is separate from their collection staff. In the early stages of the program it could be difficult for borrowers to get collection staff to refer their case to the loss mitigation group. However, interviews with servicers suggest that they may have gotten better at integrating these two functions. Servicers and counselors both reported that some of the biggest determinants of the use of loss mitigation are not related to programmatic features. Instead, two of the biggest hurdles are getting borrowers to provide the financial information needed to assess loss mitigation options and overcoming the limitations of low-income and wealth in finding a loss mitigation approach that can cure the delinquency. Among the general program features that hamper use of the program, lenders frequently cited the limit on using loss mitigation until borrowers reach a certain stage of delinquency and the requirement that properties must be owner-occupied. A very common theme in the interviews with servicers was the need for better communication with HUD to clarify program rules, grant exceptions, provide guidance about best practices, and to give Abt Associates Inc. Executive Summary vii

7 servicers an opportunity to provide input about ways to improve the program. Among other general issues raised by lenders are difficulties with the process for filing for incentive claims, mostly focused on inability to fix errors on line to expedite payment. Servicers also expressed a preference for lender scores that are more in keeping with those used by the GSEs that can be readily tracked. They would also like to have fixed standards for these scores to earn higher incentive so they can aim at specific performance goals. While for the most part lenders thought that incentive fees were adequate, a number of lenders noted that reimbursement was inadequate for expenses associated with loan modifications and partial claims since these costs offset much of the incentive fee. Finally, servicers did not view deficiency judgements as likely to increase borrower willingness to engage in loss mitigation. With regard to the use of specific tools, our data analysis showed there to be great variation among servicers in the degree to which they have been using special forbearance agreements. Interviews found that a lot of variation in use of this option may reflect differences in servicers definitions of what terms are needed to count as special forbearance as well as their willingness to use informal forbearance instead. There has also been tremendous variation in the use of the loan modification option. For the most part, this variation reflects the organizational challenges and financial risks associated with this option. Unlike modifications of conventional loans, in order to execute a modification of a FHA loan, servicers have to buy loans and then re-pool them. This often requires establishing new organizational relationships and taking on new risks. A new, and potentially significant, barrier to executing loan modifications is a limit on the interest rates that can be charged. When the rate cap is below the market rate, servicers face a major disincentive to using loan modifications. Another programmatic feature that hinders use of modifications as well as partial claims is the fact that foreclosure costs cannot be included in the amounts capitalized. These costs are substantial for FHA borrowers and generally must be paid as a condition of the modification or partial claim. The main concern expressed about the pre-foreclosure sale option is the rigid guidelines HUD has introduced about borrower and property eligibility and the sales terms that will be accepted. Servicers believe that without a provision for granting exceptions, HUD is missing opportunities to resolve defaults more cost-effectively than through foreclosure. For both pre-foreclosure sales and deeds-in-lieu, lenders noted that HUD ought to consider more generous allowances for payment of other liens. These other liens often preclude the use of these tools when the payment of the lien would be more cost-effective than going through foreclosure. Lessons from Other Loss Mitigation Approaches Fannie Mae and Freddie Mac have emerged as the industry leaders in the sophistication of their approach to encouraging loss mitigation by mortgage servicers. In many respects, the loss mitigation programs of FHA, Fannie Mae and Freddie Mac are quite similar. They all offer similar options, have similar program rules, and provide lenders with incentive fees for completing workouts. Nonetheless, the loss mitigation approaches used by the GSEs provide useful examples of alternative ways to structure loss mitigation tools, measure performance, set incentives for effective loss mitigation use, and provide feedback to servicers. The GSEs have also made extensive use of technology both to develop reporting systems to manage the loss mitigation process and to develop scoring models to identify the most efficient servicing approach for each delinquent loan. viii Executive Summary Abt Associates Inc.

8 Fannie Mae and Freddie Mac have both developed similar approaches to managing lenders use of loss mitigation. They both have devoted staff to work with servicers to approve loss mitigation workouts and to provide feedback on overall delinquent loan servicing. Fannie Mae in particular has placed a significant emphasis on this aspect of lender management, with staff routinely working on-site with servicers. The second aspect of lender management is the development of reporting systems and behavioral models to provide lenders with management tools that keep them focused on key aspects of the process. Finally, both GSEs set standards for performance measures to evaluate servicer performance and to set goals for improvement. Freddie Mac has placed the greatest emphasis on this last approach. They have developed seven performance measures, each with a series of standards as performance goals. These individual measures are combined to provide an overall servicer rating that is used to provide greater financial incentives for good performers and to punish poor performers by limiting their ability to acquire servicing rights for loans. While the GSEs play the most significant role in loss mitigation for conventional loans, the private mortgage insurance companies are obviously important actors as well. Mortgage insurers may become involved in contacting borrowers and encouraging them to seek workout options with servicers. Also, these firms generally have developed behavioral models to evaluate the risk of loss from defaulted mortgages that they will share with servicers to aid in their collection efforts. However, since the insurers are not investors, they generally do not get involved in loan modification or repayment plan options. While insurers do have an advance claim option, this tool is not as readily used as is FHA s partial claim. However, private mortgage insurers are much more involved in setting the terms of pre-foreclosure sales and deeds-in-lieu, since they will bear losses in these cases. The approach used to loss mitigation by state government agencies and non-profit organizations involves a significant emphasis on borrower counseling. In comparison, while FHA encourages the use of counseling, it is not mandatory. As a result, FHA s loss mitigation program is not associated with as much one-on-one counseling from third party counselors. However, given the volume of FHA defaults and the level of counseling services generally available, FHA s lack of a requirement for third-party counseling seems reasonable. FHA does require counseling for pre-foreclosure sales since borrowers will lose their home and there are important tax consequences from this transaction. These state and non-profit programs are also characterized by the and the use of zero-interest second mortgages to cure delinquencies, much like FHA s partial claim. However, FHA s partial claims cannot be used to pay for foreclosure costs, as is possible in some state and non-profit programs. Otherwise, the partial claim is more generous in that FHA does not limit the funds available for this purpose and allows partial claims up to 12 monthly payments, which can be substantial. Recommendations Our recommendations for improvements to the loss mitigation program are based on the findings from interviews with a wide spectrum of those involved with the program, an analysis of HUD administrative data, and a detailed investigation of the loss mitigation approaches of others in the mortgage industry, most notably Fannie Mae and Freddie Mac. For the most part, our findings suggest that the loss mitigation program provides a powerful set of tools to help borrowers resolve their delinquencies. Lenders use of the program has grown in recent years to the point that the level of workouts is similar to that achieved under the assignment program. However, there are clearly Abt Associates Inc. Executive Summary ix

9 opportunities to make better use of the program. These opportunities are evident both from the high workout rates of some FHA servicers as well as the much greater success of the GSEs compared to FHA in resolving serious delinquencies through workouts. Most of the recommendations are aimed at fostering improved use of the existing program, although a few changes are recommended in existing program rules. Improve Communication with Servicers One of the most striking aspects of loss mitigation use is the great variation across servicers in both the rate at which loss mitigation is employed and the type of options that are used. In part, this variation reflects different interpretations of HUD s expectations about when each tool is appropriate. This variation also reflects organizational challenges that servicers have had to overcome to implement the program and to use specific options. In order to foster a more uniform implementation of the program, HUD needs to establish better communication with servicers to clarify how to implement loss mitigation, to provide feedback about how a servicer s use of the program conforms to expectations, and to disseminate information on best practices. Among the approaches that would accomplish these goals are: Develop a detailed handbook for implementing loss mitigation; Foster greater dissemination on best practices at conferences, seminars and in newsletters; Assign individual HUD staff as points of contact for servicers; Create a servicer advisory group to foster routine dialogue with servicers; and Vigorously pursue penalties for those servicers who still fail to engage in loss mitigation. Develop A New Lender Scoring System The use of a performance score to provide greater incentives for lenders is an important aspect of the loss mitigation program, given the great latitude granted servicers in their implementation of the program. A carefully designed lender score can also help promote more uniform use of the program across servicers. The Department is aware of shortfalls with the current measure and has been developing alternative measures that are more closely tied to loss mitigation use. The recommendations presented here are intended to help in the development of a new lender score. Include the workout ratio as a critical component of the new score; Use a measure of foreclosure timelines rather than claim amount; Use measures that are easily tracked by servicers; Set tiers of performance standards for incentives that provide fixed goals; Get input from servicers in establishing measures and setting standards; and Report lenders performance more frequently and provide indications of relative standing. x Executive Summary Abt Associates Inc.

10 Improve and Expand Data Collection Having thorough and accurate information on delinquent loans and servicers actions is of critical importance for establishing effective performance measures, monitoring delinquent loan management, and evaluating program effectiveness. There are a variety of improvements in HUD s data collection and handling that are needed to improve and expand on the data available for these purposes. With improvements in data collection, a variety of other improvements will be possible, including better reporting tools to guide servicers delinquent loan management and the development of models to evaluate the risk of loss and define appropriate loss mitigation strategies. Improve the handling of existing data; Consider collecting more information on early delinquencies; Gather data on borrower circumstances at the time of default; and Pursue a pilot program with individual servicers to gather information and develop behavioral models. Consider Changes to Program Rules While for the most part, FHA has crafted a potentially very effective loss mitigation program there are a number of changes that ought to be considered to improve the program. The proposed changes range from being fairly minor to being fairly significant. The recommended changes are based on the accumulated experience of the mortgage industry with both FHA s and the GSEs loss mitigation programs since the mid-1990s. These changes are organized below according to those that relate to the program generally, those that deal with specific tools, and those related to incentive fees. General Program Rules Do not impose delinquency requirements for use of loss mitigation options; Expand program eligibility to allow greater use by non-owner-occupants; and Consider expanding eligibility to include more borrowers in bankruptcy. Rules Regarding Specific Tools Align borrower eligibility requirements between the partial claim and loan modification options; Allow use of loan modifications and partial claims to finance foreclosure costs; Consider allowing capitalization of some junior liens in modified loans; Change the loan rate cap for modified loans to be more closely tied to market rates; Establish mechanisms to assist lenders with loan modifications; Allow for greater flexibility in approving pre-foreclosure sales; and Consider Removing Additional Time to Complete Pre-Foreclosure Sales as an Increased Incentive. Abt Associates Inc. Executive Summary xi

11 Incentives Fees Consider reimbursing lenders for out of pocket costs; Consider providing incentives for obtaining financial information from borrowers; and Consider paying incentive fee for special forbearance only upon reinstatement. xii Executive Summary Abt Associates Inc.