Should Modifications Target a 38% DTI Ratio?

First, Hope Now servicers agreed to a broad framework for approaching streamlined loan modifications. And now, with a little push from the FDIC (as conservator of IndyMac), further details are emerging about how to apply broad-based, standardized loan modifications.

As with the Hope Now initiative, the IndyMac loan modification program unveiled last week largely targets nonconforming loans, but whereas the Hope Now alliance focused on subprime borrowers, IndyMac's response focuses on loans made to alt-A credit borrowers. And rather than anticipating defaults due to rate resets, the FDIC program targets loans that are already seriously delinquent or in default.

In contrast to most servicers, IndyMac has some clout in dealing with investors and government-sponsored enterprises these days. And the FDIC proposal has some teeth to it: asserting that modifications should reduce a borrower's debt-to-income ratio to 38%. As a ward of the FDIC, IndyMac is no longer accountable to shareholders. And given today's weak housing markets, the FDIC is in a strong position to twist the arms of the GSEs or private investors to get approval for loan mods that might not pass muster with some investors.

A key point: Is 38% the right debt-to-income ratio for loan modifications to make payments affordable?

That's the standard the FDIC has taken, and it's willing to make a lot of concessions to borrowers in order to reach a point where only 38% of a borrower's income goes to the payment of principal, interest, taxes and insurance.

Under the FDIC plan for troubled IndyMac loans, the modifications will turn existing loans, many of them with variable-rate features, into fixed-rate loans for a period of five years with the interest rate reduced to that 38% debt-to-income target. In addition to lowering the rate, the FDIC plan allows for extending the amortization period and permitting "principal forbearance" if that is needed to get the DTI ratio down.

The program could give seriously delinquent or defaulted borrowers rates well below the prevailing rate for conforming loans as measured by Freddie Mac's weekly survey.

After the five-year period, the note rate would rise up to the prevailing Freddie Mac fixed-rate mortgage interest rate, but by no more than one percentage point a year.

"It is my hope that this program will serve as a catalyst to create more modifications across the country," FDIC chairman Sheila Bair told reporters. "I think a lot of servicers will frankly welcome the program."

The 38% DTI goal, which the FDIC considers what is needed to make the modified loans affordable for borrowers, may or may not be embraced by the rest of the mortgage servicing industry. The FDIC has an incentive to be generous: it owns the assets from a failed institution such as IndyMac, but eventually wants to sell them. By turning nonperforming loans into performing assets, the FDIC believes it can sell the loans at a higher premium and give the taxpayers a better deal than they'd get in a fire sale of distressed assets.

It's not clear how servicers and investors who aren't under FDIC control will react. Ms. Bair said that for nonconforming loans, most pooling and servicing agreements are broad enough to allow the kind of modifications it is proposing. But many of the IndyMac loans were sold to the government-sponsored enterprises, and the FDIC is still negotiating with Fannie Mae and Freddie Mac over details of the program. FDIC officials expressed confidence last week that Fannie Mae and Freddie Mac will embrace the initiative.

Over time, big servicers and investors will likely have to respond to the FDIC's 38% DTI target. It will be interesting to see if the industry embraces that target for making unaffordable loans affordable.