There can be no denying the fact that the government is not in favor of forcing homeowners out of their homes, even when they are in default and facing foreclosure. Legislative bodies around the country, as well as Fannie Mae and Freddie Mac, have all taken action to stall the foreclosure process in an effort to keep more borrowers in their homes. From the early days of this crisis, the federal government hoped that lenders would begin to actively modify existing mortgages to meet this goal. While programs advanced by the U.S. Department of Housing and Urban Development (HUD) did not attract the attention of mortgage lenders, changes in the way the industry is approaching this problem—and the high risk of class-action lawsuits against those institutions that do not act—are leading more lenders to consider moving forward with mortgage modification programs.
In the end, lenders who can effectively modify mortgages for borrowers in default will be in a position to get those borrowers back on track, keep them in their homes and revitalize the income streams from these deals. With housing prices continuing to fall across the country, refinancing these mortgages is often not an option, making loan modifications the most viable strategy. But, there are a number of challenges lenders will face with this plan.
The first challenge involves attempting to modify the mortgage without giving away too much of the revenue promised by the borrower in the original deal. When lenders were offered the opportunity to refinance troubled borrowers into Federal Housing Administration (FHA) loans last year, the fact that they would have to agree to accept the proceeds of the new mortgage as payment in full of their preexisting senior loan and release their lien made the offer unappealing for many lenders as that meant that the outstanding principal balance owed would not be fully paid. Unfortunately, loan modification programs will also involve lenders leaving some money on the table. While specific features of the various programs will vary, most lenders will find that they are waiving prepayment and restructuring fees associated with mortgage modifications.
The second challenge lies in finding a way to give borrowers a deal they can still afford. By far, the most significant factor involved in borrowers getting into trouble has been their inability to pay the monthly mortgage loan payment after an adjustable-rate mortgage loan ticked up. In an effort to keep these borrowers on track, some lenders are modifying loans such that the borrowers' monthly payments (including principal, interest, taxes and insurance) fall between 31 percent and 38 percent of gross income. Lenders are doing this by reducing interest rates, extending amortizations, and/or forbearing the principal owed on the loan.
Finally, and perhaps most significant to the long-term success of the lender’s modification of a loan, lenders must deal with the fact that many of the loans they will attempt to modify have already been pooled into mortgage-backed securities that have been sold off to investors. This means that it would be prudent for the lender to determine whether investor approval is required for the loan modification. If investor approval is required, then the lender must ensure that it satisfies all of the criteria necessary to obtain approval of the modification. (Note, too, that the approval of junior lien holders may be required to modify a loan.) For the protection of the lender and the investors in these securities, proper documentation and regulatory disclosures are critical during this process.
There are three essential types of documents that must be part of any loan modification program. They include consumer disclosures, investor-related documents and the loan modification documentation.
Like any mortgage transaction, there are disclosures that must be presented to the borrower at prescribed times. The modification process changes the process somewhat. A new Regulation Z disclosure is ordinarily required when an existing obligation is satisfied and replaced by a new obligation undertaken by the same consumer. However, a workout of a delinquent loan will not require a new Regulation Z disclosure unless the rate is increased or the new amount financed exceeds the unpaid balance plus earned finance charges and certain insurance premiums.
If the rate is increased based on a variable-rate feature that was not previously disclosed or if a new variable-rate feature is added to the obligation, a new disclosure will be required. The lender will also not have to worry about providing a new notice of right to rescind under Regulation Z for a modification of a closed-end mortgage by the original creditor. However, the right of rescission will apply to the extent the new amount financed exceeds the unpaid principal balance, any earned unpaid finance charge, and amounts attributed solely to the cost of the transaction.
Lenders subject to state regulation governing mortgage lending will also be required to provide state-specific disclosures. The bottom line is, depending on the terms of the loan modification, other disclosure obligations under Regulation Z and applicable state law may be triggered. A lender may want to engage legal counsel to ensure that all required federal and state disclosures necessary to complete a loan modification are provided to the borrower.
If investor approval of the modification is indeed required, the lender should ensure that any investor-specific documents required to be included in the loan modification are, in fact, provided to the borrower and/or included in the modification package. Finally, the modification must be documented just like any other mortgage transaction. Depending upon the circumstances and applicable law, this may involve modification of both the promissory note and the security instrument. The loan modification agreement is generally always recorded.
Lenders that can effectively implement a loan modification program will fare better than those that choose to proceed with foreclosure and then take on the responsibility of maintaining properties or try to dispose of them at a loss in a weak housing market. However, before proceeding with a loan modification, lenders must be prepared to meet any documentation and investor-specific requirements for the modification to be a success.
Don Iannitti is CEO of Carson, Calif.-based Document Systems Inc.(DSI), a company he founded in 1988. His firm's DocMagic software revolutionized the mortgage document industry and turned DSI from a small southern California document service into a national phenomenon.