I had an interesting conversation with Frank Pallotta of Loan Value Group in New Jersey earlier today. Loan Value Group is an organisation that was set up to help avoid foreclosures, they use the expertise of behavioural economists from Wharton, mortgage finance experts, mortgage advisers, and consumer marketing experts, to work with lenders at risk of strategic default and likely default.
There are really only two classifications of borrowers in difficulty, those who can’t pay and those who won’t pay – Loan Value Group can both identify and work with either cohort.
We share a common view on principle reduction, Loan Value Group’s opinion is that ‘blind principle reduction’ is very negative, it addresses the consumers balance sheet, but from a working point of view for every other stakeholder its a mess. And if people are willing to lie for a 0.5 to 1% – reduction in rate then imagine the incentive if there was 10k or more in principle reduction? Therefore, we need solutions that don’t disadvantage the other parties. Who are these other parties?
1. The surrounding neighbourhood – repossessions have a negative effect on both the community and property prices as foreclosure sales help to set price ranges even though they are not always comparable.
2. Businesses in the area – there is obvious revenue loss as customers leave the catchment area.
3. Investors in the bank
4. Buyers of Securitized debts (often pension funds)
5. Governments who bailed out banks and then have to fund schemes to keep people housed.
6. The taxpayer general.
Default occurs for one of two reasons: people either can’t pay or won’t pay, there are only ever two reasons.
HAMP, if it works the right way should help the affordability issues, they are two dimensional – for those who can’t pay:- at what rate can you pay? The willingness issue is tougher to identify and tougher to fix. There have never been this much negative equity in the world… Ever.
Behaviourally they work very closely with the team at Wharton, they developed the programme itself and used some economic theory to create the programme, the lottery effect, salience and other concepts to change their view as to why they are in this transaction.
“People pay for shelter, some for investment, and when the incentive of the investment is gone it becomes about shelter, and you can get that anywhere for cheaper. Investor loans fall first because it isn’t about shelter at all, its about investment.”
people leave at different LTV’s for different reasons, there are intangibles that cause people to stay or go for various reasons, churches, schools and other things in the area. LVG created the infrastructure for rolling out their retention model and they have the expertise with which to identify the place/s with the greatest risk of strategic default, from there they go to work with the people on a private label basis, done so in a way that the client feels they are being reached with a credible alternative that has them at the centre.
Their programme can take as little as 48hrs to implement, its FAST, as opposed to months on end for a modification programme.
Forward conditional principle forgiveness with a built in claw-back is the answer they have come up with. The borrower gets the reward but only when the conditions are satisfied – they have several institutions live with the programme, and while the scheme sounds attractive, it must be remembered that the number of live borrowers at present is less than 1,000.
This brand of forbearance helps to ensure the person doesn’t walk away. if their DTI (debt to income) is 45% and their LTV is 190% people will almost always walk away. People are currently avoiding their house payments because they need their car (which is easy to repossess) and they know they can’t get thrown out of a house as easily as they’ll lose a car.
LVG’s message to banks: Why not hedge your current borrowers? If you know 2 out of 10 may go down and you’ll lose 50-60 points then why not spend a little money to stop them from going down? If you spend some cash to stop those from defaulting from defaulting then all you have to do is dissuade a few borrowers from defaulting.
It is very cheap to implement – the size of the reward in every case is substantially less than the loss incurred by a foreclosure/repo. If a person buys a house for 120k have a 100k mortgage, their LTV is 83%, if their value goes to 80k, now your upside down, if your value is 80k the bank might only recover 40c on the dollar after it goes wrong.
This is a combination of legal costs, time, lost income, forbearance costs, internal costs, credit collection, additional servicing, liquidations of mortgage backed securities. So if the bank stands to lose 60pts then in many of the cases it may only take a 10k reward (meeting in the middle) – I’m giving you 10k, to get the 10k all you have to do is repay your mortgage. Its a 10point liability ONLY when the mortgage pays off, if the person stays it could be 8-10yrs down the road. The future value isn’t as high.
In a liquidation the present value is far lower than the present value of the loss, so banks need to get a solution, Loan Value Groups offering is turnkey and private label for the banks, so they don’t need to develop the banking infrastructure, by not touching the mortgage note they can surpass legal and accounting issues that would normally come into play. it has to be administered and rewarded a certain way, it doesn’t violate contract law or accounting practices [Note: This point in particular is relevant to mortgages in the USA].
Second lien holders are also signing up to this plan, borrowers react to those that will help them, so when you call the borrower and say “Here’s some good news, you owe X amount on your 2nd lien (1st lien reward is 10-15points, on a 2nd lien – because the lender can lose everything – they’ll pay up to 40-50 points), make 24 payments and you’re done, you won’t have to pay back all the money, this is a reward for continuing to pay”.
Loan Value Group will look at between 12 and18 characteristics in any community going between the lender and the borrower to get the offering to potential defaulters right. There isn’t a history (yet) to base results upon, but there has been huge interest and they have signed up a large (Forbes list company but they can’t say who yet) financial firm who want to roll out their product as soon as possible – because the traditional methods for dealing with borrowers are not working. Time will tell if the behavioural approach works or not, but you certainly can’t knock Loan Value Group for tackling an old problem in a new direction.
You can check out their website (borrower end) at www.RhReward.com