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Mortgage Crisis
By Marc R. Gilmore
The Problem:
As property values around the country began to soar in the late 1990’s and early
2000’s, it became ever more difficult for many people to afford to buy homes. Many
people could not assemble a 20% down payment, and others could not afford the high
monthly payments required under traditional fixed-rate mortgages. However, at the same
time, banks began to loosen lending standards, no longer requiring substantial down
payments or permitting piggy-back loan structures to circumvent the absence of a down
payment. In addition, lenders used adjustable-rate mortgages and other “innovative” loan
instruments to make mortgages appear more affordable to borrowers. In many cases,
though, insufficient consideration was given to the borrowers’ ability to continue to make
payments once the grace periods or introductory terms of those loan instruments expired.
The Objective:
The goal is to stem the increasing wave of defaults and foreclosures by borrowers
who can no longer afford their mortgage payments. This is best accomplished by
reducing the borrowers’ monthly payments to affordable levels without imposing the full
cost of loan modifications on the lending institutions or on the government. This paper
describes a tenable way to accomplish these seemingly irreconcilable goals.
The Solution:
The best way to countermand the threat of default and foreclosure from dramatic
increases in monthly mortgage payments is to find an intelligent way to reduce the
required monthly mortgage payments to their initial level, or to some other level – either
somewhat higher or lower than the initial level – that the borrower can afford, but to do
so without unduly jeopardizing the interests of the lending institution. In order to
evaluate the options for lowering the monthly mortgage payments, it is useful to examine
the formula used for calculating those payments.
I derived and worked with the following formula:
x = iS0 * (1-(1/(1-(1+i)^N)))
where:
• x: the monthly mortgage payment
• i: the monthly interest rate
• S(0) or S0: the initial loan balance
• N: the number of months in the term of the loan
x = S0 * (i / (1-(1+i)^-N))
Monthly mortgage payments depend on the size of the loan, the term of the loan,
and on the interest rate. Changing any of those three variables will affect the monthly
mortgage payment. Currently, most proposals have focused on adjusting the interest rate
on the loan, which in the formulas affects the term i. Adjusting the interest rate is the
simplest way to adjust the monthly mortgage payment, and is perhaps the most apparent
option, but it is not the most effective approach. There are two significant problems with
reducing the monthly mortgage payments by altering the interest rate. First, in order to
return a mortgage payment to its initial level the lender would have to reduce the interest
rate back down to the introductory interest rate level. This would prevent the lender from
earning the expected return on the money it has lent. Second, incremental decreases to
the interest rate result in non-linear concomitant decreases in the monthly mortgage
payment. In other words, reductions to the interest rate yield diminishing returns in the
effect on the monthly mortgage payment.
Like adjusting the interest rate, changes made to the term of the loan result in
diminishing returns. However, the advantages from increasing the term of the loan are
much less significant than those realized from adjusting the interest rate.
In contrast, reductions made to the principal amount of the loan will result in
proportional, concomitant decreases to the monthly mortgage payments. Thus, adjusting
the outstanding principal of the loan is the most effective way to reduce a borrower’s
monthly mortgage payments. The question then becomes, how does the lender determine
by how much the principal must be reduced in order to return the borrower’s payment to
its initial level? The answer is through the use of an “equivalency equation.”1
In order to set up the equivalency equation, we examine three values: x1, x2 and
x3. The value x1 represents a borrower’s monthly mortgage payment during the
introductory period of the loan. The value x2 represents the borrower’s monthly
mortgage payment after the conditions of the loan have reset, resulting in a substantial
increase in the required monthly payment. The value x3 represents the monthly mortgage
payment that is to be modified, and to be returned to the same value as x1.
When the conditions of the loan reset, the monthly payments increase, and the
ratio x2/x1 represents the percentage by which the payments have increased. This is an
important constant, which will hereafter be referred to as the “payment increase ratio.”
In order to set up the equivalency equation, we start from the premise that we
want x3 to be equal to x1. However, without modification, x3 will not be equal to x1, but
instead to x2. But we can make x3 equal to x1 if we multiply the unaltered value of x3
(which is the same as x2) by the inverse of the payment increase ratio. In other words:
1
These payments comprise elements of principal and interest only. They do not include elements of
property taxes or insurance because those components vary from state to state and even from borrower to
borrower. Also, it is assumed that those elements will not experience intra-year changes.
Solving that formula for S3, which will provide the level to which the outstanding
principal of the loan should be reduced, we get:
Because the payment is being modified within a static period, both the variables N and i
are fixed. That means that any terms containing only those variables cancel out. That
leaves the equivalency formula as:
Thus, for any static modification period, in order to return the monthly mortgage payment
back to its initial level, the level to which the outstanding principal balance must be
reduced can be calculated simply by multiplying the unmodified outstanding principal
balance by the inverse of the payment increase ratio. However, if the borrower has
missed one or more payments, then the full formula must be applied across the two
distinct payment periods marking the period of default and the period at which the
modification will be implemented.
Of course, the lender may wish to set the new monthly mortgage payment to a
higher or lower level than the borrower was initially paying before the conditions of the
loan reset. Recently, many have called for limiting a borrower’s required payments to the
level of 40% of the borrower’s income. The equivalency equation can be modified very
easily to calculate the principal reduction required to result in any desired payment. This
may be effected by the use of a multiplier which consists of the desired payment level
divided by the pre-reset payment level. The modified formula may thus be expressed as:
The question then becomes how the lender can reduce the principal without
simply forfeiting the money. The answer is to structure the reduction to principal as an
investment by the lender. This can be accomplished by the parties executing a loan
modification agreement. The investment should be structured such that the lender
obtains an inchoate, or as-yet unrealized, equity stake in the property in question. The
lender’s stake in the property should be calculated as a percentage of the value of the
property. In order to calculate that percentage stake, an independent appraisal should
first be made of the property to determine its current market value. Then the lender’s
percentage stake should be calculated by dividing the amount of principal invested by the
current appraised value of the house. Thus, the lender’s percentage stake in the property,
P, is calculated as:
The lender will receive payment on its equity stake at the time the property is sold. That
payment should be calculated by multiplying the lender’s percentage stake by the sale
price of the property. That payout is calculated as follows:
Should it be the case that, upon the sale of the property, the equity built up in the property
is not sufficient to fully remunerate the lender for its stake in the property, then the
borrower will be personally liable to the lender for any shortfall.
The mortgage modification agreement should also state that, in the event the
borrower retains the property for the full term of the loan, then the lender will have the
option either to retain its percentage stake in the property until such time as the property
is sold, or to require the borrower to repay the payout value (based on a then-current
assessment of the value of the property) of the property in the form of a mortgage, to be
agreed by the parties on fair conditions.
Of course, if the amount of the lender’s required investment appears too great, the
lender can use the equivalency equation to find a suitable combination of reducing the
principal and adjusting the interest rate to yield the desired monthly mortgage payment
for the borrower. However, the reduction to the outstanding principal should still be
treated as an investment by the lender, and the lender’s percentage stake in the property
should be treated as described herein.