Joint Fund Could Enable Small Banks to Assist Underwater Borrowers

A private-government partnership fund could assist “underwater borrowers” and actively engage small-size banks in national efforts to speed up the housing market recovery, according to a mortgage market veteran.

An entity that pools capital from various resources into a fund designed to mark mortgage loans to market prices and facilitate sustainable modifications may be a solution, says Abraxas Discala, CEO of the Broadsmoore Group, a merchant bank that buys positions in small-size firms and mortgage banks that need investor support to improve or diversify their business operations.

Mortgage market investment risk is high today due to various factors including HAMP and other government intervention programs that drained out liquidity from the banking system to fund “modifications that did not pay off” still is keeping many potential investors in the sidelines. Since one of the biggest challenges with modifications is how to deal with related loan losses, according to Discala, one solution could be to take a second lien on the mortgage and place it into the joint fund.

Depending on the amount of equity the borrower is losing on the property, or how much principal is forgiven, “they would have a limited upside on their first mortgage and the second lien would have the most upside,” he says. It would require a real appraisal and principal forgiveness that would bring loan values down to the mark-to-market level.

For example, if a borrower has a $300,000 loan on a property that is worth $250,000 today, the loan would be modified after giving the homeowner $50,000 worth in “true forgiveness.” The second mortgage, valued at $50,000, is then originated by the fund, giving “an upside” in value to the $250,000 first mortgage. The $250,000 option would be placed in this jointly owned government-private sector fund that can be monetized by offering interested buyers real estate options.

Discala argues that if enough money is placed in this fund, it can serve as a tool that can help certain mortgage markets hit a true bottom—which is a win-win for everyone. Investors in this fund "would definitely see return on their investment down the road.” While the banks’ mark-to-market related losses would go into the fund as second liens not in their balance sheets. It means such a fund could be “in the billions,” he says.

Given the size of the national debt and the federal bailout money already used to soften the consequences of the mortgage crisis such a fund may be unrealistic. But in his view smaller banks with substantial amounts of troubled mortgage assets in their balance sheets would be very interested to invest in such a fund, so they are “eager to discharge these assets in exchange for mark-to-market values.” Many investors, too, especially pension funds are now ready to invest in such funds that could help rebound the U.S. real estate market.

Customers win, too, Discala says, because mortgages on properties that currently are under water would get modified to a loan-to-value that is realistic—even though determining accurate mark-to-market values is a challenge. The fund would create an incentive for people who are under water “to not throw the keys on the table” and avoid strategic defaults. It can assist delinquent borrowers who want to stay in their home and have the ability to repay their mortgage if they qualify for a modification.

He argues that reducing foreclosures down the road does not mean “to give everybody a free ride,” which in his view has been the case with HAMP. A joint-fund solution structured as a not-for-profit corporation that benefits from tax deductions would equally help smaller-size banks and their customers.

“I do not advocate bailouts, but this could be a reasonable way to assist underwater borrowers,” he says. HAMP was designed to assist borrowers who lost their ability to pay due to job loss or other hardship are unable to pay the mortgage for an indefinite length of time. Differently from HAMP such a fund would assist borrowers who are relatively stable financially, or whose ability to pay their mortgage has not changed significantly—while the amount of equity in their property has drastically decreased.

Research findings indicate home values have continued to decline. Research data from different sources are mixed. For example, starting in 1Q 2010 Seattle-based Zillow Real Estate Market Reports showed several metro areas in California had already reached bottom in 2009 and were showing signs of improvement. Zillow chief economist Stan Humphries described such changes as “a very positive sign that several large markets have hit what appears to be a tentative bottom in home values," but since has repeatedly warned there is no guarantee that home values will not fall again even in the best performing areas and probably will remain at 2010’s lowest point.

Since it is unclear when home values will hit bottom and start to bounce up, Discala says, “we need new ideas.”