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The mortgage default pipeline.

The segment of U.S. residential loans either seriously delinquent or foreclosed has dipped to the lowest level in almost five years. This has caught many by surprise. [paragraph] The sharpness of the decline was unforeseen, especially when considering the sheer magnitude of the housing crisis and the ensuing tsunami of residential property defaults and bank and government-held real estate--owned (REO) properties it produced. [paragraph] So what happened? [paragraph] The crisis spawned a number of game-changing events and countermeasures, which combined to alter the landscape and materially contribute to the results we have witnessed. [paragraph] A number of these measures are likely to produce more enduring structural changes. As such, we should incorporate these important factors and lessons learned in the development of more-precise forecasting tools. [paragraph] Severe delinquencies declined almost 30 percent year-over-year in September 2013. REO rates declined over the year by almost 28 percent. [paragraph] Mortgages entering the foreclosure process during the third quarter of 2013 were down 13 percent from the previous quarter and down by almost 40 percent from the previous year.

Foreclosure starts in the third quarter of 2013 were at the lowest level since the second quarter of 2006. These declines can be largely attributed to the following interrelated factors:

* a slowly improving U.S. economy with historically low interest rates for a sustained period;

* unprecedented regulatory, legislative and legal actions;

* expanded loss-mitigation activities;

* standard refinancing and enhanced streamlined refinancing options;

* regional differences; growth of non-bank servicers;

* bulk sales and investor participation; and

* higher-quality newer-vintage loans.

Clearly, some of these elements are more significant than others. For example, historically low interest rates and the strengthening economy, together with unprecedented loss-mitigation efforts and foreclosure-prevention activities, have materially contributed to the decline in distressed properties.

The regulatory, legislative and legal actions generally encouraged loss-mitigation and other foreclosure-prevention activities while also triggering a lengthening of foreclosure time frames.

There were several other lesser factors that in aggregate have also made a meaningful contribution--namely the shift of servicing from bank to non-bank servicers, bulk mortgage servicing sales and increased investor participation.

The economy

We have witnessed a slow and steady (albeit fragile) improvement in the U.S. economy since the credit crisis and the start of the Great Recession. The improved economy is reducing the number of loans becoming delinquent and facilitating loss-mitigation actions.

In many parts of the country, we are also seeing the supply of available properties for sale decreasing while the demand for housing has increased.

The positive trends--especially with regard to house-price appreciation and improved employment numbers--have materially contributed to the decline in severe delinquencies and foreclosures.

U.S. house-price appreciation continued in August 2013, with prices rising 0.3 percent on a seasonally adjusted basis from the prior month, according to the Federal Housing Finance Agency (FHFA) monthly House Price Index (HPI).

The August HPI change marks the 19th consecutive monthly price increase in the purchase-only, seasonally adjusted index. The Northeast had the lowest price gain, at approximately 8 percent, and the West had the greatest price gain of almost 18 percent.

Home prices have brought many underwater borrowers into positive equity positions and further strengthened newer-vintage mortgages that already had positive equity. This pricing trend is likely to continue as the distressed-property inventory contracts, reducing the overall supply and the volume of discounted homes used as comparables in appraisal reports.

As expected, housing affordability is declining in all regions as housing prices and interest rates have risen (see Figure 1).

The unemployment rate has dropped steadily from 10 percent in late 2009 to 7.8 percent in 2012 and 7.2 percent by October 2013 (see Figure 2). These improvements may be somewhat overstated, however, because they do not fully reflect the fact that many of the unemployed have stopped looking for work.

We have also experienced record-low interest rates for the past four years. The 30-year fixed-rate mortgage averaged 4.13 percent in the week ending Oct. 24, which is less than 1 percentage point above the record low that occurred during September 2012.

Many factors have complicated the outlook for distressed properties going into 2014. Some are permanent, some are temporary, but all are critical to predicting the pipeline.

These sustained low interest rates have helped housing by strengthening demand, facilitating refinancing of higher-rate mortgages and contributing to house-price appreciation.

The U.S population grew by more than 14 million during the last few years, with an associated demographic shift as household formations also grew, although at a slow pace.

In addition to that population increase, investors have entered the single-family market. Also, many of the borrowers who had financial problems during the crisis are now aspiring to re-enter the housing market as they begin to recover.

Spurred by the housing crisis, residential housing construction plunged starting in 2008 and has remained at historic lows, despite some recent improvements (see Figure 3). Accordingly, this has reduced the overall supply of new housing in many parts of the country.

Regulatory, legislative and legal intervention

The past several years have brought an unprecedented level of regulatory, legislative and legal interventions. These have particularly targeted default servicing and focused on preventing faulty foreclosures and encouraging loss-mitigation activities.

One of the most significant actions was the National Mortgage Servicing Settlement (NMSS). In February 2012, 49 state attorneys general and the federal government announced a joint state-federal settlement with the country's five largest mortgage servicers: Ally/GMAC, Bank of America, Citi, JPMorgan Chase and Wells Fargo.

The settlement provides as much as $25 billion in relief to distressed borrowers and direct payments to states and the federal government. It represents the largest multistate settlement since the 1998 Tobacco Settlement.

The mortgage settlement provides benefits to borrowers whose loans are owned by the five banks as well as to many of the borrowers whose loans they service. The settlement encourages lenders to negotiate lower rates with existing borrowers and reduce principal amounts owed.

More recently, the Office of the Comptroller of the Currency (OCC) also issued new foreclosure guidelines to large and midsized banks in April 2013. The guidelines outlined some minimum standards that must be met before a foreclosed home can be sold.

The OCC's guidance largely consists of 13 questions banks should answer before selling a home in foreclosure. Such questions include whether the borrower is in an active loan-modification plan or if the borrower is protected by bankruptcy. In response, a number of banks suspended foreclosure sales for a period of time to ensure their foreclosure practices complied with the new requirements.

Additionally, many state and local governments have implemented measures to try to protect borrowers from improper foreclosures. For example, in 2011, Nevada's legislature enacted Assembly Bill 284, which threatens criminal penalties for bank officials who do not follow new rules to certify that foreclosures were being processed properly. It also made it a felony to make false representations related to real estate title.

More recently, the Nevada legislature passed State Senate Bill 321, also known as the Homeowner's Bill of Rights, during the 2013 legislative session. Beginning Oct. 1, 2013, banks and mortgage servicers in the state must take additional steps before filing notices of defaults, the first step in a foreclosure process, or taking possession of a property.

Another relevant example is the state of California, which enacted its own Homeowner Bill of Rights law that went into effect on Jan. 1, 2013.

The law pertains to first-lien mortgages that are secured by owner-occupied properties with one to four residential units. The bill also carries stiff penalties and the potential for lawsuits against lenders that make foreclosure missteps.

The law prohibits dual-track foreclosures, where a lender forecloses on a borrower despite being in ongoing discussions over a loan modification to save the home.

It also guarantees struggling homeowners a single point of contact who has knowledge of their loan and direct access to servicing decision makers, and imposes civil penalties on fraudulently signed mortgage documents.

In addition, homeowners may require loan servicers to document their right to foreclose and can access courts to enforce their rights under this legislation. Similarly, a foreclosure-prevention law that passed in Maryland in 2010 added mandatory mediation to the state's foreclosure process.

These and other interventions have triggered more loan modifications and other loss-mitigation activities. They have also slowed down the foreclosure process--especially the end of the process--because servicers can continue to work with borrowers to pursue collection and loss-mitigation options after a foreclosure referral.

Yet, by slowing down their foreclosure process, servicers have kept non-remediable distressed properties frozen longer in the default pipeline. This is further amplified by the backlog servicers are facing.

In some regions of the country, this has created a shortage of available residential real estate at a time of increased demand. The end result has artificially driven up prices and spurred new housing construction despite an oversupply of severely delinquent properties.

Loss mitigation

Loss-mitigation and foreclosure-prevention activities have been encouraged, expanded and extended since 2009. Under the Department of Housing and Urban Development's (HUD's) Home Affordable Modification Program (HAMP), more than 1 million homeowners had received a permanent modification as of the end of March 2013.

The government-sponsored enterprises (GSEs) completed almost 3 million foreclosure-prevention actions since the fourth quarter of 2008. During the first half of 2013 alone, the GSEs' fore-closure-prevention actions saved approximately 247,000 borrowers from foreclosure.

Ultimately, these measures have cured or delayed many loans from moving through the foreclosure process and into RE0s. For example, to further facilitate loan modifications, on July 1, 2013, Fannie Mae and Freddie Mac implemented new enhancements to their Streamlined Modification program. The enhanced program does not require a Borrower Response Package (BRP), and the servicer is not required to verify the borrower's income or that the borrower has an eligible hardship.

HUD also streamlined its Federal Housing Administration (FHA) loss-mitigation process and created clearer eligibility parameters for each loss-mitigation option. Mortgagee Letter 2012-22 announced these revisions and required implementation by Feb. 16, 2013.

HUD also adjusted its loss-mitigation eligibility criteria to widen the population of borrowers who may qualify for the revised loss-mitigation options. Additionally, with the issuance of Mortgagee Letter 2013-23, on July 9, 2013, HUD revised FHA's pre-foreclosure short-sale requirements and introduced a streamlined pre-foreclosure sale process aimed at removing certain obstacles for borrowers to obtain a short sale.

Ultimately, these measures stop many loans from moving to REO. More recently, HUD issued a new notice that includes updated guidance on non-wage income to be used in loss-mitigation evaluations. This new policy allows income not related to employment, such as disability or Social Security benefits, to count toward eligibility for an FHA loan modification, which further expands the loan-modification program to encompass more borrowers and loans. Under the previous guidance, borrowers had to be employed to be eligible for a loan modification.

Further, these programs are being extended beyond their previous end dates. On May 30, 2013, the Department of the Treasury and HUD announced that they were extending HAMP for non-Fannie Mae and non-Freddie Mac loans until the end of 2015. HAMP was originally scheduled to end at the end of 2013. The Federal Housing Finance Agency (FHFA) also directed Fannie Mae and Freddie Mac to extend HAMP and their Streamlined Modification program initiative through the end of 2015. Eligibility for the streamlined modification initiative was originally expected to run through August 2015.

To further expedite loss-mitigation activities, Fannie Mae and Freddie Mac aligned their mortgage servicing requirements, and are adjusting their guidelines to be more consistent with the Consumer Financial Protection Bureau (CFPB) mortgage servicing rules, scheduled to take effect Jan. 10, 2014.

Refinancing programs

Thanks to the low-interest-rate environment, many borrowers have refinanced their loans and reduced their monthly payments. Further, significant efforts have been made to help underwater borrowers refinance.

HUD implemented significant price cuts to the FHA Streamline Refinance program in 2012. Specifically, FHA lowered its upfront mortgage insurance premium to 0.01 percent and reduced its annual premium to 0.55 percent for certain FHA borrowers. Additionally, borrowers with loan balances that exceed the current value of their home (negative equity) are not disqualified. To qualify, borrowers must be current on their existing FHA-insured mortgages that were endorsed on or before May 31, 2009.

The Home Affordable Refinance Program (HARP) has also assisted more than 2.2 million borrowers to refinance since April 2009. HARP is aimed at current homeowners with high-loan-to-value (high-LTV) mortgages with a maximum of 125 percent LTV. HARP underwent a number of changes to enable more borrowers to qualify; the LTV was originally capped at 105 percent and there was a cap on the LTV of the resulting loan. More recently, the program was extended for two years beyond its scheduled expiration date of Dec. 31, 2013.

These refinancing programs have lowered the monthly costs on legacy underwater loans and provided borrowers with more sustainable mortgages, which should reduce the risk of future defaults. However, as interest rates rise, refinancing will obviously become a less-viable option.

Regional differences

Foreclosure speeds differ substantially among states, and in some cases there are differences even among counties. There is no one set of unified foreclosure standards; each state handles its real estate foreclosures differently.

Judicial foreclosures are processed through the courts and generally take longer. Non-judicial foreclosures are processed without court intervention, with the requirements for the foreclosure established by state statutes. As such, each non-judicial foreclosure state has different procedures.

Some states such as California, Maryland and Nevada have implemented laws that add another layer of complexity to the process. Additionally, some states experienced greater appreciation during the housing boom, including some areas of California, Florida, Arizona, Nevada, Oregon and Colorado. Thus, when the housing bubble burst, these states were shackled with larger inventories of defaulting loans.

Bulk sales and investor participation

Bulk sales of distressed properties have been gaining momentum. HUD significantly expanded the use of distressed single-family loan sales through a competitive bidding process. HUD sold more than 16,000 seriously delinquent mortgages in March 2013, about 15,000 in June 2013 and approximately 5,000 in July 2013. HUD expects to auction more loans this year.

Additionally, FHA completed a Claim without Conveyance of Title (CWCOT) pilot program to facilitate third-party sales at foreclosure auctions and encourage servicers to sell REOs without conveying the foreclosure properties to FHA asset managers.

Twelve of the largest servicers of FHA-insured loans are currently participating in this program. The bulk sales are further reducing the inventory of distressed properties.

Investors have emerged as significant buyers of distressed properties. Approximately 10 percent or more of all properties sold are generally purchased by institutional as well as small investors. The percentages are generally higher in states that have larger inventories of distressed properties.

About 5 percent of all Fannie Mae REOs are acquired by investors via bulk sales. Many are acquiring distressed properties and converting them into rentals. For example, New York-based Blackstone Group LP, through its Invitation Homes national platform, has invested approximately $5.5 billion in the single-family home rental space. In early November 2013, Blackstone and Frankfurt, Germany-based Deutsche Bank AG completed the first-ever rated securitization that is based on REO-to-rental properties.

Newer-vintage loans

Thanks to all these actions, fewer pre-2009 loans remain and the newer-vintage mortgages are of markedly better quality. These newer mortgages are defaulting at very low rates thanks to more conservative underwriting standards and rising house prices.

Additionally, many lenders are applying more-stringent credit overlays on top of strengthened GSE and FHA guidelines. Against the backdrop of the declining number of outstanding legacy mortgages, this segment of newer-vintage loans is becoming more critical, and the anticipated implementation of the Qualified Residential Mortgage (QRM) and the Qualified Mortgage (QM) rules will likely ensure that future originations are also less likely to default.

Non-bank servicers

Mortgage servicing is performed by banks and non-bank servicers, with the large banks still dominating the mortgage servicing landscape. Recently, however, there has been a growing shift in mortgage servicing volumes from banks to non-bank servicers, and this trend is expected to continue.

The seven largest non-bank servicers accounted for $1.4 trillion in mortgage servicing by the end of the first quarter of 2013--an increase of almost 145 percent compared with the previous year.

With the new Basel III rules, banks will be increasingly motivated to sell more of their servicing, and non-bank servicers are expected to continue to increase their share. I estimate that non-bank servicers may add another $1 trillion or more to their servicing portfolios.

Non-bank servicers appear to be more efficient and adept at managing loss-mitigation activities and processing foreclosures. Accordingly, the shift to non-bank servicers has had some impact on reducing severe delinquencies and fore-closure timelines on the mortgages they service.

Determining the outlook for distressed properties

Building mortgage default forecasting models has never been an easy undertaking, but the level of complexity has increased substantially as a result of the structural changes in the economy and the mortgage landscape.

Not surprisingly, it has been difficult to anticipate the steepness of the decline in severe delinquencies, foreclosures and REOs that has been taking place recently.

Many industry participants did not expect such a steep decline. This mistake may have been especially costly for firms specializing in this segment of the market, including REO asset managers, real estate brokers, property preservation companies and real estate foreclosure-centered law firms. Some companies might have been overly optimistic in their earnings forecasts, which may have led to inappropriate operating decisions and/or investments.

I expect that distressed properties (severe delinquencies, foreclosures and RE0s) will continue to decline in 2014. To avoid future mistakes and possibly gain a competitive advantage, firms specializing in this sector of the mortgage market should consider shifting to a more robust forecasting framework. mit

The past several years have brought an unprecedented level of regulatory, legislative and legal interventions.

By slowing down their foreclosure process, servicers have kept non-remediable distressed properties frozen longer in the default pipeline.

Bulk sales of distressed properties have been gaining momentum.

Alex Kangelaris is a senior director with Treliant Risk Advisors in Washington, D.C. He can be reached at
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Author:Kangelaris, Alex
Publication:Mortgage Banking
Date:Dec 1, 2013
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