Mortgage Banking & Consumer Credit Alert
November 2008
Author:
Laurence E. Platt
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larry.platt@klgates.com
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EESA: No Guarantee of Federal Loan Guarantees
Press reports claim that the Federal Deposit Insurance Corporation (“FDIC”) and Treasury are close
to announcing a plan pursuant to which the federal government will guarantee the repayment of
modified eligible residential mortgage loans held by private parties. We have not yet seen a copy
of this proposal, and, quite frankly, we are not convinced that the proposal will morph into a real
program. As events unfold, we want to take the opportunity to highlight certain issues for which you
should watch if a loan guarantee program actually is promulgated by Treasury.
The Emergency Economic Stabilization Act of 2008 (“EESA”) created the Troubled Asset Relief
Program (“TARP”) pursuant to which Treasury is authorized to purchase “troubled assets,” including
residential mortgage loans, from qualifying “financial institutions.” We are still waiting for Treasury
to announce both the appointment of a whole loan asset manager to oversee the loan purchase
program and the establishment of eligibility and pricing policies pertaining to such purchases. If
Treasury were to buy and hold distressed loans from holders, it obviously could modify the loans in
most any way it wants to without the need for issuing insurance to protect itself. (See our October
17th alert: “No Fault Loan Modifications After EESA: Charity Begins at Home?”)
Section 102 of EESA provides an alternative to the outright purchase of loans by Treasury. It
authorizes (but does not mandate) Treasury to guarantee the timely payment of principal of, and
interest on, troubled assets in amounts not to exceed 100 percent of such payment, based on such
terms and conditions as are determined by Treasury consistent with EESA. Participating lenders
will have to pay risk-based premiums for such insurance. Treasury must base the amount of such
premiums on its determination of what is necessary to create reserves sufficient to meet anticipated
claims, based on an actuarial analysis, and to ensure that taxpayers are fully protected.
EESA provides for the creation of a Troubled Assets Insurance Financing Fund into which insurance
premiums shall be paid and invested and out of which claims will be paid. While the idea is that
the claims will be funded solely from premiums, EESA contemplates that the $700 billion purchase
authority granted to Treasury under EESA might be necessary to backstop the insurance fund. EESA
provides that such purchase authority granted to Treasury shall be reduced by an amount equal to
the difference between the total of the outstanding guaranteed obligations and the balance in the
Troubled Assets Insurance Financing Fund.
Congress added this insurance authority after the first failed vote on EESA. It was a Republican
requirement to provide an alternative to massive loan purchases by the federal government. In lieu
of using taxpayer money to purchase loans, why not use loan holder money to pay for insurance
premiums. Rather than holding billions of dollars on the government’s balance sheet, the government
would receive revenues in the form of insurance premiums to assume a contingent liability to pay
insurance claims in amounts in excess of the invested premiums. In her recent testimony to the
Senate Banking Committee, FDIC Chairwoman Sheila Bair announced that FDIC and Treasury
were developing plans to implement this Section 102 authority.
Assuming that the loan guarantee plan will be announced, there are sure to be some basic issues with
which the government and loan holders will have to grapple.
1. What residential mortgage loans will be eligible for loan guarantees?
One of the major policy stumbling blocks on loan modifications is who is eligible for relief. Should
the program be limited to subprime or ALT-A, owner-occupant borrowers who obtained teaser rate,
non-traditional mortgages (payment option ARMs or interest only ARMs) or hybrid ARMs (2/28
or 3/27) in 2007 or before? As the economy worsens, it is clear that declining property values and
Mortgage Banking & Consumer Credit Alert
changing economic circumstances are having a material
adverse impact on a much wider swath of borrowers than
those who may have knowingly stretched (and perhaps lied)
to obtain a subprime or ALT-A loan. Does a prime borrower
who owes more on his or her house than the house is now
worth have a less compelling need for a guaranteed loan
modification than the subprime borrower? Should eligibility
be based on brutal personal need or loan characteristics? This is an extraordinarily difficult public policy question that
routinely gets lost in the government “jawboning” about loan
modifications but cannot be avoided in the creation of a new
federal loan guarantee program.
An important issue is whether loans in mortgage backed
securities that qualify for REMIC treatment will qualify for
loan guarantees. We know that there are legal limitations on
modifying such loans based on their payment status. This is
a different issue, though. Without removing the loans from
the pool, may modified loans backed by a new loan level,
federal guarantee remain in the pools? In other words, can a
new form of collateral be dropped into the securitized pools
without disrupting the legal treatment of the securities?
2. What is the difference between an FHAinsured, refinancing mortgage loan under
the HOPE for Homeowners Program, and a
Treasury guaranteed modified loan?
Earlier this year, Congress enacted the Housing and
Economic Recovery Act of 2008, which created the HOPE
for Homeowners Program (the “HOPE Program”). Under
the HOPE Program, the Federal Housing Administration
(“FHA”) has special authority to insure residential mortgage
loans made to refinance distressed loans in default. (See our
September 2nd client alert: “Must Hope for Homeowners
Mean Losses for Lienholders?”) It is not at all clear whether
the HOPE Program will succeed, because of two major
reasons. First, it is exceedingly complex, particularly with
respect to the required shared equity and shared appreciation
features. Second, it is anticipated that loan holders will have
to write down on a permanent basis the existing indebtedness
to be refinanced by a significant amount in order to fit within
the maximum mortgage criteria for a new FHA-insured loan
under the HOPE Program.
So why does the government need to create a new program
to guarantee existing loans if it already can insure loans that
refinance such existing loans? In either case, the government
is not required to buy the loans and the government receives
insurance premiums for its assumption of the risk of credit
loss. As noted above, it is quite possible that the HOPE
Program will be a complete bust—a victim of its own
complexity both in terms of the risks borne by lenders who
elect to make such loans and the lingering uncertainty about
the legal and practical aspects of the shared equity and shared
appreciation features. Of course, in the absence of written
guidelines, it is possible that any new loan guarantee program
will be similarly complex, but Treasury has broad authority to
design the loan guarantee program and is not weighed down
by the statutory limitations found in the HOPE Program. This means that a new loan guarantee program might prove
to be more popular to loan holders.
More importantly, there is a material similarity between the
HOPE Program and any new loan guarantee program that
likely will have a material impact on the ultimate success
of both programs. Both are predicated on the need to reduce
the monthly mortgage payments of eligible borrowers to
what are perceived to be long-term, sustainable payments. Whether the existing loan is refinanced with a new FHAinsured loan or modified on a permanent basis, the end
result will be reduced monthly payments by the mortgagor
who otherwise faces foreclosure based on the existing loan’s
original terms.
3. Will loan holders permanently write
down the existing indebtedness by the
amount necessary to qualify for a
loan guarantee?
Loan servicers (and their lawyers) can regale you with
stories of being caught in the middle between state attorneys
general and members of Congress, on the one hand, who
articulate the likelihood of consequences for those who
fail to modify loans in an aggressive, permanent manner,
and loan holders, on the other hand, who either by mail or
by phone threaten lawsuits for breach of contract if their
best interests are not respected in the loan modification
process. Neither the HOPE Program nor any new federal
loan guarantee program can change this dynamic. In each
case, the question is whether the size of the required writedown likely will cost the loan holder more than anticipated
losses from foreclosure? If not, it is an easy call to modify. If so, implementing the permanent write-down may lead to
investor law suits. The important point is that, unless the
government itself owns the loans, permanently modifying
loans to promote long-term sustainability will not work if
the cost of the modification exceeds the cost of foreclosure,
unless the holder elects to accept less than it otherwise
believes it could obtain through foreclosure. State attorneys
general are trying to attack this paradigm by claiming that
the terms of the original loan are not fully enforceable based
on alleged origination deficiencies, and that claim may have
traction in some circumstances but not others. Without such
permanent write-downs, however, no federal loan guarantee
will be available.
November 2008 | 2
Mortgage Banking & Consumer Credit Alert
4. Given the write-downs that it will take
to qualify an existing loan for a HOPE
Program refinancing or a federal loan
guarantee, why not just sell the loans to
Treasury under TARP?
At this point, loan holders do not know whether they will
be able to sell their troubled loans to Treasury and, if so, for
how much and on what terms. It is possible that Treasury
will purchase the troubled assets at a discount from par. This
could cause the seller to realize a loss that is the economic
equivalent to the write-down required to qualify for a loan
guarantee or an FHA-insured refinancing. As a result, loan
holders are not in a position at this time to compare and
contrast the relative economic benefits among the three
potential sources of federal help.
5. Does a federal loan guarantee provide
a comparative advantage to loan holders
over the HOPE Program or TARP?
A refinancing under the HOPE Program or a sale to Treasury
under TARP enables the loan holder to get the loan off its
books. Assuming for the sake of argument that the permanent
write-down required to qualify for a loan guarantee is no
more than the economic loss suffered by the holder under
the HOPE Program or TARP, why would the holder elect
to keep the loan and pay a premium for the loan guarantee? As a threshold matter, it is not at all clear that a loan holder
would make that choice; after writing off a material amount
of indebtedness, the additional requirement to pay a mortgage
insurance premium does not sound inviting. Yet, for those
who would like to keep the loan on their books, the guarantee
could insulate the loan holder against the risk of recidivist
delinquent behavior by borrowers. Indeed, if and to the extent
the original delinquency is caused by a material adverse
change in economic circumstances, the risk of further
defaults resulting from further deterioration would be shifted
to the federal government. Only time will tell whether this is
enough to make a difference.
6. How will Treasury ensure that the
insurance premiums are sufficient to
meet the statutory standard of actuarial
soundness?
It is ironic that FHA has fought unsuccessfully for years
to use risk-based insurance premiums in its regular FHA
program only to find that Congress granted such authority
to Treasury in EESA for the federal loan guarantee program. Section 2133 of the Housing and Economic Recovery Act
imposed a 12-month moratorium on the Department of
Housing and Urban Development (“HUD”) prohibiting it
from implementing risk-based premiums. What does Treasury
know about setting risk-based insurance premiums that FHA
does not? It is likely that Congress did not make a conscious
choice between HUD and Treasury on this point. More likely,
Section 102 of EESA was a compromise required to gain
enough votes for EESA’s passage. In any event, it does not
appear that Treasury has any particular expertise in this regard
and, yet, any risk undertaken in excess of available reserves
is debited against funds available for capital infusions and
troubled asset purchases. It is this dilemma that makes me
wonder how real this new program actually is.
November 2008 | 3
Mortgage Banking & Consumer Credit Alert
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