Going Upstream

If a lender won’t or can’t modify, why wait until they foreclose? Some groups are taking matters into their own hands with note purchases or short sale programs.

Rosalyn Keith used to run her own private dental practice in Tempe, Ariz., but over the past few years fighting to keep her home from foreclosure became so stressful and time consuming she mothballed her business and started working as an employee for another practice.

What brought Keith to that point was a whole bouquet of the sorts of things that have been wrong with the mortgage system over the past decade. She bought at the height of the real estate bubble. A friend set her up with her original loan, which turned out to be a predatory, high-interest ARM. She suffered with the high payments for years and had finally secured approval for a modification to a new, fixed-rate, affordable loan a few years ago. But before the paperwork was completed, her loan was sold to another servicer.

The new owner not only didn’t honor the modification, but didn’t contact her with information on how or where to pay until she was behind enough that they claimed they had “no choice but to foreclose.” From there, Keith was launched into a repeating series of payment plans, foreclosure rescue scams, unscrupulous or over-priced attorneys, servicers who tried to foreclose after having sold her loan (again) to someone else, mortgage interest she paid not reported to the IRS, and so on. She never received a loan modification.

“The experience has been a total nightmare and many times I felt there was no way out,” she says. The ordeal has wrecked her credit so badly she figures she would have trouble qualifying for many apartments if she did lose her house. Besides, she loves her home, and after a dozen years there she is attached to her friends in the neighborhood, her church, and local places where she volunteers.

So when a group called Second Opportunity of Arizona, (SOAZ) told her they had bought her loan, Keith can be forgiven for basically thinking, “Here we go again.” But luckily for her, SOAZ is different; it was created in order to buy loans for the goal of foreclosure prevention. The people at SOAZ “are the only ones who haven’t asked me for any money,” says Keith. “Everyone else has asked me for thousands and thousands of dollars.”

Marcos Morales, president of SOAZ, worked with Keith to complete a sustainable loan modification that met her needs. “He kept in constant contact with me,” says Keith. “Most importantly, he did what he said he was going to do. He is my housing angel. I hope others going through my struggle will have someone like Marcos in their corner.”

Why Buy Loans?

Keith could clearly have used a housing counselor through her ordeal with the other servicers and lenders. But SOAZ didn’t just provide her free HUD-certified counseling. It came with an enormous amount of extra power to help: The program actually owns her loan and the contract with the servicer, so it has the authority to design and implement a loan modification without seeking approval from someone else. For Keith, this meant she finally got principal reduction and modified terms that allowed her to keep her home and start back on the path to financial stability and credit worthiness.

A good loan modification, with principal reduction, is an obvious win-win-win situation. The homeowner, provided they can afford a loan on the house at the current market value, keeps their home, preserves their credit, and gets a more affordable payment. Investors avoid the additional loss that would happen if the loan went to foreclosure. And, of course, the neighborhood benefits by reducing the serious negative effects of having another building go vacant.

But for a host of reasons — some structural, some habitual, some having to do with misaligned incentives on the part of lenders and servicers — HAMP and bank-driven modification programs are not reaching everyone who could actually afford to keep their homes.

Frustrated with seeing families lose their homes unnecessarily and with struggling to clean up the REO mess while neighborhood values and stability decline, some community development advocates have decided to take matters into their own hands, going upstream to get control of homes pre-foreclosure. One way to do that is by buying pools of delinquent loans and modifying them themselves.

As George Ostendorf of American Mortgage Capital Group explains, although many advocates have been frustrated trying to get lenders to sell them specific individual loans, pools of distressed loans are being sold to hedge funds and large investors all the time. These private buyers do modify and refinance a portion of the loans, but the short time frame and expected returns from their investors means there are many more they “liquidate,” with the predictable consequences for the neighborhoods where those loans cluster.

At a National Housing Institute-organized discussion between capital markets and neighborhood stabilization representatives in December 2010, Ostendorf told those in the room that he thought the missing ingredient for many of those loans was not subsidy, but merely patient, below-market capital.

Patient, below-market capital is something the nonprofit and public sectors have better access to than the for-profit sector. A few organizations present at that discussion were already looking at Hardest Hit Funds — repaid TARP money that the Treasury distributed to 19 states hardest hit by foreclosures — as a great way to get into the business of buying pools of notes.

Arizona Loan Purchases

In Arizona, National Council of La Raza, (NCLR) recognized the need to move upstream early on, in 2007, but couldn’t get lenders interested, recalls Lautaro Diaz, NCLR vice president of housing and community development. Then in 2010, Diaz and Erik Sten of Further Development, who was working on a similar project in Oregon, started talking about the fact that Arizona’s Hardest Hit Funds weren’t getting spent. Arizona had chosen to use its HHF to offer incentives to lenders who wrote down principal in their loan modifications. Problem was, lenders weren’t really participating. So Diaz and Sten thought it was time to try the idea of note purchases again.

Hogar Hispano, an independent economic development group spun off by NCLR, and Further created a separate corporation, Second Opportunity of Arizona (SOAZ). SOAZ asked the state to set aside a portion — $40 million — of those HHF incentives for them; their plan was to leverage those promised funds to raise private capital to buy pools of loans, with the intention of modifying them with principal reductions. As loan owners doing principal reduction modifications, they would then qualify to receive the state HHF incentives, which would cover the program’s operating costs.

The state agreed in Spring 2011, and by October 2011 SOAZ had raised its initial $1 million and commenced on a tiny pilot project — two loans, one of which was Rosalyn Keith’s. As of February 2012, they had acquired a third loan and were working on setting up additional loan purchases. They hope to ramp up dramatically from the initial pilots, having worked out the details, but getting investor commitments will be crucial.

If they can raise enough capital to qualify for all the incentives their MOU with the state reserves for them, they would be looking to purchase 1,200 to 1,500 notes over the next 18 months to 2 years, depending on purchase price.

Diaz says that what defines “getting to scale” with something like SOAZ would be conducting enough transactions to calm a jittery marketplace. “One of the major problems with the real estate market is that credit has been cramped down,” he says. “There is no certainty in the real estate markets anywhere. There is no secondary market.” The goal is to stop the downward spiral in perceived value, he says, which a note adjustment can do. He hopes that when lenders see “six months of stable values” they might start to adjust their perception of risk.

Mortgage Resolution Fund

By far the most ambitious stab at delinquent loan purchases for the purpose of stabilization is the Mortgage Resolution Fund, a multistate partnership between Mercy Portfolio Services, National Community Stabilization Trust, Enterprise Community Partners, and the Housing Partnership Network. As of press time, the partners were operating under confidentiality agreements until their first deals close.

Based on publicly available documents and preliminary concepts that were released, however, the basic outlines are that MRF will use its HHF awards as essentially a loan loss reserve, leveraging it one to one to raise private capital for acquisition.

They expect to purchase pools of mortgages in areas where private purchasers are less interested in buying, such as judicial states where long foreclosure times hamper the quick exit that private distressed asset purchasers require. Their model is to buy those pools at a price that will allow them to provide principal reductions down to the current market value and run the program unsubsidized off the difference. Working with a network of counseling agencies, they expect to modify the loans they can, season them for a while, and sell/refinance them so they can recycle the money to help new homeowners. For those that are not modifiable, they plan to conduct short sales or deed-in-lieu proceedings, focusing on smooth transitions that leave the borrower in a stable position.

MRF is looking at 500 to a couple thousand mortgages per state. They are engaging a private company in the field on a fee-for-service basis to handle special servicing and due diligence of loan pools. If all goes according to plan, they should be able to return the HHF money to Treasury when the program ends.

Treasury approved $100 million for MRF in Illinois in June 2011. Gov. Pat Quinn said at the time, “With this unique coalition of housing leaders, we are able to stretch this federal resource further with the involvement of private partners and help more people stay in their homes.” On November 22, 2011, MRF finalized approval for a test phase of $25 million in Illinois, and it is working actively to get HFA and Treasury approval in a few other states.

From Notes to Short Sales

The state of Oregon was one of the first out of the gate with a specific plan to use Hardest Hit Funds for note purchases.

The model of Oregon’s Loan Refinancing Assistance Pilot Project, (LRAPP) was fairly simple and similar to MRF’s, though smaller scale. Focusing on two counties, Jackson and Deschutes, that have high rates of foreclosure, the program intended to seek pools of delinquent, underwater loans on owner-occupied properties, buy them for less than the market value of the occupied home (but more than the lender would recover if they had to proceed through a foreclosure), and work with nonprofit housing counselor partners to develop modifications that involved principal reduction to the current market value and an affordable, sustainable payment. A typical borrower in the program would be 50 to 100 percent underwater on his or her home, and though employed have experienced some sort of permanent lowering of his or her income.

LRAPP would then season the loans while helping borrowers repair credit and pay off other debt until they were ready to refinance into a conventional, sustainable loan and recycle the proceeds to help a new household. The LRAPP intended to bring in private capital on the refinance end, rather than the acquisition end as with MRF.

But when Oregon went to implement, they ran into a problem. Because the target area is small — only 300,000 people — finding a single lender who had a sufficient concentration of loans to sell a pool in that geography wasn’t happening, and the lenders had no infrastructure to sell individual loans. While it wasn’t forbidden, the lack of standard procedure for a note sale proved to be more of a barrier than anyone had foreseen. In addition, two-thirds of the loans in LRAPP’s target counties were held by the GSEs, which don’t sell loans at all.

And so, says Erik Sten of Further Development, which is administering the program for the state of Oregon, they changed tacks and decided to go for short sales instead. Lenders and servicers have an established mechanism for short sales — even if it is imperfect and slow. In fact, doing short sales enables the program to work with local real estate agents who are familiar with short sale negotiations, drawing on their expertise and supporting local businesses/jobs in the process.

In the short sale approach, the borrower is the seller, rather than a lender selling a pool of notes. This means the program can meet with and pre-underwrite each participant for the program and know that all the money it spends will go to borrowers who qualify for a mortgage at current market value and will be able to stay in their homes. “They’ve demonstrated to us that they can afford the new mortgage,” emphasizes Benjamin Pray, public affairs manager for Oregon Housing and Community Servicers. “There’s no ongoing subsidy.”

“One of the problems with the loan sale process,” says Sten, “is there is a randomness as to who it can help. If we are working with you, the likelihood that your loan is in a pool for sale is low. [The short sale approach] allows just about any family who qualifies to participate.”

Once a short sale offer is accepted (the big question mark is what the acceptance percentage will be), the home is sold to Further Development. At the same closing, Further sells the home back to the homeowner at the current market value, originating its own mortgage (fixed-rate, 6 percent). Further then sells the mortgage note to the state, which will hold it until the owner is able to refinance to a lower rate or the state builds a large enough portfolio to refinance them as a group. The only difference from a typical short sale, from the lender’s perspective, is that the borrower can’t sign the usual form stipulating that they are vacating the premises.

The downsides of the short sale over note sale approach are a smaller discount (in the range of 10 percent so far), and possible larger effects on participants’ credit scores. However, notes Sten, most participants are already delinquent, so their primary concern is saving their home, not their credit score, for which the best medicine is a payment they can stay current on. The one-by-one negotiations will also necessarily limit the scale somewhat.

Oregon has allocated $10 million in HHF to this program so far, and as of late February, two sales had closed and over 50 offers had been placed. The first two sales each had principal reductions of about 50 percent, and Sten said it’s hard to describe how excited the homeowners were when they walked out of the closings: “That’s a pretty life-changing event.” Both homes were in the tiny town of Redmond, Ore., and since they closed, “I think the whole town is calling us,” says Sten. “These are towns that have been hit pretty hard. They need some hope.”

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