Last month the Federal Housing Finance Agency (FHFA) asked for input on a plan it is considering to augment the Real Estate-Owned (REO) disposition programs run by Fannie Mae and Freddie Mac (the Enterprises) and the Federal Housing Administration (FHA). The deadline for proposals is tomorrow. Radar Logic, a data and analytic firm, responded with an innovative dual proposal for developing "cash market equivalent" values for real estate assets and reducing the inventory of owned real estate (REO).
The first of what Radar Logic refers to as its two prong approach would allow for aggressively restructuring the delinquent mortgages held by FHA and the Enterprises by replacing existing mortgage debt with a modified mortgage and a bundle of securities that would contain debt and equity elements - a Equity Participation Certificate (EPC) - to either be retained by the entities or sold on a type of secondary market.
Radar Logic maintains its proposal, if implemented, would significantly reduce the immediate loss on the loan that would occur through foreclosure and offer the incentive of additional profit downstream for the lender, for an investor, and for the homeowner should he remain current on the restructured debt. Using an example provided in the proposal, the debt/equity scenario would work as follows.
Loan in the original amount of $190,000 has been paid down to a current principal balance of $186,310. A foreclosure and subsequent sale of REO is estimated to recover $99,000. The loss suffered by the Enterprise will be $88,000.
Based on borrower information and the appraised value of homes in the area the mortgage is restructured at $125,000. This would result in a loss of $61,000, a 27 percent larger recovery than if foreclosed.
Radar Logic's "EPC" Proposal
The proposal submitted to FHFA envisions the loan restructure as outlined above plus the creation of an EPC which would package the $61,000 remaining debt along with the potential for any future increase in the equity value of the home. The accounting result is to convert the distressed loans into a right to share in the upside appreciation of the relevant property. The homeowner will be granted a portion of the appreciation rights, giving him an incentive to remain current on the new loan and maintain the condition of the property. The lender could hold the EPC in anticipation of an increase in value of the underlying collateral or could sell it to investors. The loss to the lender is, at this point, still 27 percent less than through a straight foreclosure however the scenario envisions selling the EPC for 10 percent of its face value, or $6,100 for a final realized loss that is 33 percent less than if the lender had foreclosed and liquidated the REO.
It is Radar Logic's contention that "the initiation of this program will reduce the perception of over-supply in housing significantly, which will cause the cash value of the participation certificates to increase immediately. If the EPC portfolios held by the Enterprises and the FHA are managed properly over time, all losses might be avoided and even a profit might be realized.
No new resources would be required to implement the program according to the proposal. The strategy can employ the resources that are currently focused on loan modifications such as HAMP and existing resources within the Treasury or Federal Reserve can execute the required capital market activity.
The risks of such a program include redefault of the restructured loan. The EPC model however mitigates this risk because rather than a straightforward elimination of debt it substitutes a security for the portion of the distressed loan that no longer represents normal value in today's housing market. This results in a reduction in payment for the homeowner without an immediate and unrecoverable loss to the lender. Further, as long as the similar guidelines are applied, the default risk will be no higher than for other modification programs or for new borrowers under FHA supported programs.
The second risk is that no meaningful home price appreciation occurs. Radar Logic feels that the rebalancing of supply and demand should result in an increase in buyer activity and thus an increase in values.
The second prong of the company's proposal is to rent vacant REO properties. The plan currently under consideration by FHFA is the bulk sale of REO to private, presumably institutional investors who would refurbish and rent them as business ventures. Radar Logic finds two problems with this proposal. First, investors will only buy if they can forecast an adequate return on their investment which would require a discount that would result in a larger and permanent loss to the Enterprises and ultimately the taxpayer. Second, the sale of these properties in bulk at fire sale prices will put further downward pressure on the market. This would result in lower future appraisals based on these comps and still further price depreciation as well as possible cancellation of pending sales because they cannot be financed. The actual REO in question is only a small piece of the country's inventory overhang so selling it at distressed prices may undermine normal activity without the benefit of substantially clearing the market and enabling renewed activity.
Radar Logic suggests having a bulk sale without the actual sale. Properties would be organized geographically and bids sought from qualified private investors to restore and manage those homes as investment assets on behalf of the government owners. This would create private sector jobs in both rehabilitation and management as well. By retaining ownership the Enterprises and FHA will suffer fewer losses than a bulk sale would impose, immediately reduce the existing oversupply of homes for sale, and conceivably see a profit as the markets improve.