by Tanta on 8/29/2008 09:49:00 AM

Having done my share of griping about the FDIC's plan for modifying IndyMac loans, I feel obligated to point out that I didn't describe the program as fully and accurately as I might have. This is a problem I must rectify.

I'm not, apparently, the only one who missed the implications of the FDIC's use of the term "principal forbearance" in the context of this plan. An RBS research report on the potential impact of the plan for IMB securities that was published recently uses the terms "principal forbearance" and "principal reduction" interchangeably. A new JP Morgan report, however, which was recently updated and republished after someone spent some time asking the FDIC for further information (smart move), clarifies for us exactly what the FDIC means by "principal forbearance."

To remind everyone, the FDIC approach is to arrive at a total housing-payment-to-income ratio or HTI, which they confusingly call a "DTI," of 38%. This can be achieved by using one or more of the following restructuring approaches.

First, the interest rate is lowered to the current Freddie Mac survey rate for fixed rate mortgages, and fully amortized as a fixed rate loan. As far as I can tell, at this initial step, the loan is amortized over its remaining term, whatever that is.

If that is not enough to achieve 38% HTI, then the interest rate is "stepped" for up to five years. That means that the initial rate is set no lower than 3.00% for the first year, and increased each year by no more than 1.00% per year, until it hits the Freddie Mac survey rate (which was 6.50% at the time FDIC published). This does not make the loan an ARM or subject it to negative amortization; the payment is re-amortized each year after the interest rate "steps up" until it hits the permanent rate. That means that the loan is always paying some principal from the inception of the mod.

Remember that ARMs involve potential rate increases; whether they happen or not, and how far they go, depend on future (unknown) movements in the underlying index. A "step loan," which is what I understand these mods to be, has scheduled rate increases that are exactly specified in the modification agreement, and which are not subject to future market rate fluctuations: each loan will "step up" to the permanent rate, regardless of what happens in a year or four to market interest rates. So the borrower gets the same kind of long-term "rate lock" of a fixed rate loan--the rate will never be higher than 6.50% (or whatever the Freddie rate is on the day the mod is drawn up), and after the initial "step" period it will never be lower than that. The step period simply "ramps" the borrower into the fully-amortized payment at 6.50% by starting out with a fully-amortized payment at a lower rate and slowly increasing that rate each year until the final rate is achieved.

If the "rate stepping" all the way down to 3.00% isn't enough to hit a 38% DTI, then the whole thing is recalculated with a 40-year term, rather than with the remaining term of the loan. This part won't mean much if the loan was originally a 40-year term (and lots of OAs were) and it's only a year or two old. However, if the loan was originally a 30-year, extending the amortization term by another 10 years may reduce the payment enough to hit the 38% limit. The tricky part here for securitized loans, though, is that some and possibly most of these securities have a maximum loan maturity of 30 years written into the deal docs. So the modification will not actually extend the legal maturity date of the loan to 40 years; it will simply create a balloon loan (principal due in 30 years but payment calculated over 40 years).

If the term extension, added to the rate reduction, still doesn't hit the number, then and only then will the FDIC use "principal forbearance." The real issue I wanted to get to today was that part. What the FDIC apparently means by "principal forbearance" is not what most people think they mean by "principal reduction." The rate reduction on these loans, in contrast, is a true permanent reduction in the interest rate: the borrower is never in any scenario obligated to "make up" or pay back the difference between the original interest rate and the reduced rate.

However, with the principal, what the FDIC is doing is not forgiving principal but offering an interest-free forbearance of repayment of part of the principal. This means that the actual principal amount due and payable at maturity of the loan (or sale of the property) is the original unmodified principal amount, less any and all periodic principal payments the borrower makes until maturity or sale. However, the contractual payment the borrower makes is no longer "fully amortized," it is partially amortized, because a portion of the loan's principal is excluded from the amortization calculation, essentially making that portion a zero-interest balloon payment. (There may already be a balloon payment on this loan, if its original term was less than 40 years. But that balloon is not zero-interest. Confused yet?)

Here's an example: the remaining principal balance of the loan at modification is $100,000. We have already gotten down to a 3.00% first-step rate and a 40-year amortization, but the payment still results in an HTI greater than 38%. Therefore we take, say, 10% of the balance out of the amortization formula, meaning we calculate the payment on a $90,000 balance at 3.00% for 40 years. That would reduce the loan payment from $357.98 to $322.19. The remaining $10,000 in principal is still secured by the mortgage, so it would be due and payable in a lump sum (a "balloon payment") at the original maturity date of the loan. If the borrower sold the home or refinanced prior to maturity, the $10,000 is due and payable at the time, in addition to the remaining balance of the rest of the loan ($90,000 less amortized principal payments).

So "principal forbearance" does not mean principal "forgiveness." It certainly means that the effective interest rate on such loans is lower than the Freddie Mac survey rate, discounted for the stepping or not, because the contractual interest is not charged on the entire loan balance. It certainly means that the investor is going to have to write down the forborne principal when the modification is done, since this falls under the accounting rules that make you write down a loan to the amount considered collectible, and it is clear that a loan in this much trouble, with property values where they are, probably is not going to pay you back 100% of principal. But if, in fact, property values recover in the future and the home sells for at least the total loan amount due, the investor will receive that forborne principal back as a recovery.

This is not the same thing, technically, as a "shared appreciation" provision; it's rather more a compromise between shared appreciation and outright principal forgiveness. The borrower never has to pay the foregone interest on the forborne principal out of future sales proceeds or in any way "make the investor whole" for the rate reduction. But unlike outright forgiveness, the borrower does have to pay the full principal amount back out of sales (or refinance) proceeds.

Which, of course, leads us to wonder what happens if there's never enough sales proceeds to pull this off. My guess is that we're going through all this "principal forbearance" business, which isn't exactly easy for your average consumer to understand, because investors like it better than outright forgiveness and it's supposed to mitigate the "moral hazard" problem. But the other side is that the FDIC or whoever buys that portfolio of modified loans is going to face the possibility of being confronted with a cohort of loans needing short sales or short refis in a year or two, because some borrowers will always need to move on before home prices "recover."

At some level, it seems a bit odd to do this elaborate "forbearance" of principal in the original workout, only to have to cave in and do outright forgiveness of principal down the road in a second workout involving a short sale. The FDIC, I suspect, is making a rather different set of assumptions about how long-term the commitment to homeownership is likely to be in a portfolio like IndyMac's, and how long it will take for property values to recover, than I would. After all, this FDIC program is not--unlike, say, the new FHA short-refi program--reducing principal to achieve "above water" loans. It is forbearing principal only as a last resort, if the rate reduction and term extension doesn't work, and only enough to hit an "affordable" monthly payment. That means it is possible that loans could get a principal forbearance that still leaves them underwater; they just become "affordable" underwater loans. And that, unfortunately, is what puts you at risk of having to do a short sale down the road when the borrower needs to move or just can no longer handle having 38% of pre-tax income going to the house payment with all the other bills they have.

The JP Morgan analysts note that maximum principal forbearances on the IndyMac portfolio aren't likely to be that much: even a loan that originally had an HTI of 60% (which is extremely high even for stated income loans; remember that this isn't DTI or total debt-to-income ratio) and that got a 400 bps rate reduction plus a 10-year term extension would require only about a 17-18% principal forbearance to hit 38%. A loan that started out with a 45% HTI would be unlikely to need any principal forbearance at all, because the rate and term adjustments would be sufficient. The difficulty for analysts of the IndyMac-serviced loan pools, both securitized and unsecuritized, is that we don't really know what current (real) HTIs are. We have reported DTIs--total house payment plus all other monthly debt--but those were based on original reported income. We are pretty sure that actual current income for these borrowers is less than what was originally reported, but since databases stopped reporting HTI and DTI, relying solely on DTI alone, we don't know how many of these borrowers have high DTIs resulting from very high house payments and not much other debt, versus relatively reasonable house payments and a lot of other debt. The FDIC's approach will help the former but not the latter. While an 18% principal forbearance may sound like a lot, in terms of IndyMac's actual loan portfolio it may not work out to much if only a tiny sliver of loans have HTIs that high (and managed to make even the first payment). The real impact on investors will be the interest reductions and cash-flow changes resulting from slowing down the amortization to 40 years.

Bottom line: there just isn't a free lunch, not for anybody.

(Hat tip to Hoover for sending me the Morgan report. Hat tip to Morgan analysts for clarifying this subject. Note to Morgan analysts: the past tense of "forbear" is "forborne," not "forbeared." Y'all owe me a new keyboard.)