**Third Report**

**Evaluation of 601 Accelerated Claims**

Disposition Demonstration

**U. S. Department of Housing and Urban Development**

**February 17, 2006**

**Table of Contents**

[Executive Summary i](#__RefHeading___Toc127848902)

[Glossary of Terms and Abbreviations i](#__RefHeading___Toc127848903)

[Background on the ACD Demonstration Design and JV Processing
1](#__RefHeading___Toc127848904)

[How ACD Works 1](#__RefHeading___Toc127848905)

[Outcomes 1](#__RefHeading___Toc127848906)

[Homeownership Retention 1](#__RefHeading___Toc127848907)

[Costs and Recoveries 1](#__RefHeading___Toc127848908)

[Claims Model 1](#__RefHeading___Toc127848909)

[Claims Model Estimation 1](#__RefHeading___Toc127848910)

[]{#__RefHeading___Toc127848902 .anchor}Executive Summary

The Accelerated Claims Disposition (ACD) Demonstration is designed to
provide an alternative disposition strategy for delinquent Federal
Housing Administration (FHA) loans. Enacted as Section 601 of the
Appropriations Act for Fiscal Year 1999, ACD gives the Department of
Housing and Urban Development (HUD) the authority to experiment with a
more flexible method of paying claims for FHA-insured loans and
disposing of foreclosed, single-family properties. The legislation
permits the Federal Housing Administration (FHA) to accelerate the claim
on delinquent mortgage notes and transfer them to a public/private joint
venture (JV) for disposition. FHA sells the notes to the JV at a
discounted price determined by competitive bid. The JV then manages the
restructuring of notes for securitization and sale or the foreclosure
and property sale of non-performing loans. FHA retains an equity
interest in the partnership undertaking asset disposition.

This is the Third Interim Report of the Evaluation of the 601 ACD
Demonstration, reporting progress on the first three Joint Ventures
(JV2002, JV2003 and JV2004) between HUD and the private partners. The
purpose of the evaluation is to determine whether JV processing of
seriously delinquent mortgages is cost effective under existing
conditions or feasible alternatives. The evaluation also considers
whether JV processing enhances HUD's ability to achieve policy
objectives, including homeownership retention. In order to determine the
cost effectiveness and policy impacts of JV processing, the evaluation
compares the outcomes of JV loans to a 10 percent holdout sample of
loans that met the eligibility criteria for JV processing. The holdout
loans receive standard FHA processing---that is, servicing by a
participating servicer (p-servicer) using standard FHA techniques of
loss mitigation or foreclosure and then disposition of foreclosed
properties by management and marketing (M&M) contractors. The evaluation
compares the claim rates and loss rates between the JV loans and the
holdout sample and also compares the extent to which JV and standard FHA
processing result in homeownership retention.

The first JV (JV2002), which began in October 2002, has reached 93
percent final resolutions as of August 31, 2005. The holdout loans from
the same period have attained 67 percent resolutions including 18
percent reinstatements. Faster disposition is a common characteristic of
the JVs. While it was expected that most of the ACD loans would have
gone to foreclosure without aggressive intervention, only 22 percent of
ACD and 18 percent of holdout loans have been sold as REO (as of August
31, 2005). Managed by Citigroup, the remainder of the ACD resolutions
have involved note sales, including a large securitization sale.

The second JV (JV2003) began in August 2003 and has resolved 80 percent
of its loans. Two major changes in JV2003 are the national coverage and
the lower JV discount rate (29 percent for JV2003 vs. 38 percent for
JV2002). The discount rate is the JV purchase price of the loan relative
to the Broker's Price Opinion of the underlying property. Another
difference for JV2003 and subsequent JVs is that the loans come from a
pipeline of delinquencies rather than a combination of a designated pool
and pipeline as in JV2002. Managed by Lehman, JV2003 is resolving loans
faster than JV2002 by selling notes in moderate-sized batches as they
become ready. Despite the 10-month lag, JV2003 has a higher share of REO
sold (25 percent for JV2003 vs. 22 for JV2002) with another 7 percent in
REO inventory. The low share of REO sold for the 2003 holdouts may
partly reflect slower disposition, but even if all the REO inventory and
foreclosure in process ended in property sale, the REO share would be
less than 35 percent. The low share of REO for either ACD or holdouts
shows a common difficulty for participating servicers in selecting the
high-risk loans for provisional approval or ACD treatment.

The third JV (JV2004) began in June 2004 and the managing partner,
Citigroup, has resolved 42 percent of the loans. The JV discount has
dropped to 19 percent and FHA's ownership share has increased from 30
percent for the earlier JVs to 40 percent for JV2004.

The homeownership retention rates are approximately the same between ACD
and holdouts, though a lower level for the 2003 cohort corresponds to
the higher rate of REO sale. The homeownership determination is
preliminary for those cases with interim status, e.g., 33 percent for
2002 holdouts and 44 percent for 2003 holdouts. Once those cases have
reached final resolution, it will be much clearer whether ACD does a
better job than standard FHA processing at preserving homeownership.

In terms of financial results, JV2002 has a lower average claim cost
(106 percent) relative to unpaid principal balance (UPB) compared to 116
percent for the holdouts. The ACD loans also have a higher net recovery
rate (69 percent) relative to holdouts (65 percent) owing to high
recoveries for Paid in Full (PIF) and note sales (nonforeclosure
resolutions). However, the JV loss rates for PIF and note sales are
substantially higher than for the holdouts due to the JV discount.
JV2002 loans have an average discount of 38 percent. Every loan starts
ACD with a significant discount, which is a loss from HUD's point of
view. Even the PIFs for ACD have a loss rate of 24 percent compared to a
holdout loss rate of 0.4 percent. Holdout PIFs or reinstatements have
small claims from loss mitigation, but those claims are much smaller
than the JV discount. The ACD loss rate for all the final resolutions is
33 percent compared to 10 percent for the holdouts. The gap between
those loss rates is likely to narrow significantly as the holdout
resolutions catch up to ACD and the foreclosures go to REO sale. There
are 33 percent of holdout loans in interim status nearly three years
after default compared to only 7 percent in interim status for ACD. It
is reasonable to expect most of those properties to end in foreclosure
with a lower recovery rate from difficult to sell properties than
recorded to date. Lower recovery rates on seasoned REO will increase the
holdout loss rate (10 percent) more than the ACD loss rate (33 percent).
Nevertheless, it is unlikely that the first JV will have losses less
than the comparison group of holdouts.

The financial results for JV2003 show lower claims costs and higher net
recovery rates, so the gap in loss rates is a little less large. The
claims costs for REO are 105 percent for ACD and 111 percent for
holdouts. The net recovery for REO is nearly the same between ACD (68
percent) and holdouts (67 percent). Higher recoveries for PIF and note
sales lift ACD recovery rates to 75 percent. JV2003 is interesting
because the REO loss rate (34 percent) is less than the holdout loss
rate for REOs (36 percent). Accentuating lower loss rates for ACD REOs
is one way that JV can reduce losses compared to standard FHA
processing. Despite lower losses on REOs and smaller loss rates for PIF
and note sales relative to JV2002, the overall loss rate for JV2003
resolutions is 26 percent compared to 12 percent for the holdouts.
Again, that gap will likely narrow as holdout foreclosures become REO
sales and the holdout loss rate increases, but the gap is unlikely to be
closed.

The recovery rates seem to fall with seasoning, but the downward trend
may be a national phenomenon not connected to ACD. The FHA recovery
rates declined by 2 to 3 percentage points since last year particularly
in the Atlanta (-1.4 points) and Philadelphia (-3.1) Homeownership
Centers.

A claims model is estimated on FHA delinquencies from 2001 in order to
predict what would have happened to the ACD loans under standard FHA
processing. The 2^nd^ Interim Report used the 1997 cohort of
delinquencies. There was concern that the differences in loss mitigation
treatment and M&M contractor property disposition might make 1997 loans
a poor control for the 2002 loans even though the 1997 loans have more
time to resolve. Another change is to estimate the probability of
conveyance claims rather than all claims as a way to focus on the
largest claims and the distinction between REO and non-REO sales. The
conveyance claim model could also be more useful for scoring loans
according to the probability of foreclosure without the dilution of much
smaller loss mitigation claims. The new model works well in predicting
conveyance claims for the 2002 and 2003 cohort of holdouts. The model
also shows that ACD reduces the REO sale rate 2 or 3 percentage points
from what could have been expected under standard FHA processing. ACD
treatment seems to restructure some notes that would have gone to
foreclosure. It is possible that such restructuring will preserve
homeownership for some ACD cases in the long run. Targeting to high-risk
loans is likely to make this restructuring more difficult because fewer
loans would reperform and thus become viable note sales.

A Glossary of Terms and Abbreviations follows the Executive Summary.

[]{#__RefHeading___Toc127848903 .anchor}Glossary of Terms and
Abbreviations

**601** **Program** -- refers to Section 601 of the Department of
Veterans Affairs and Housing and Urban Development, and Independent
Agencies Act, 1999. Section 601(d) amends Section 204(g) of the National
Housing Act to allow for structured financing such that FHA retains an
equity interest in a partnership and the private partner manages the
asset disposition. The 601 Program is also called ACD or the JV Program.

**ACD** -- Accelerated Claims Disposition Demonstration (also called 601
Program or JV Program). ACD represents the alternative of delinquent
loans being selected for prompt claim payment by FHA and the loan being
transferred to a joint venture in which the private partner sells the
loan without FHA insurance for the best available price.

**BPO** -- Broker's Price Opinion, the report that values properties at
the time a loan is submitted for ACD claim.

**Eligible loans** -- remaining set of provisionally approved loans
after holdout loans and ACD loans have been selected out. Delinquent
loans cycle through eligibility with new delinquent loans becoming
provisionally approved and older delinquent loans losing eligibility.
Provisional approval status only lasts for 60 days. In any month,
eligible loans could be drawn into the set of holdout loans or selected
for ACD treatment. More information on the eligibility criteria is found
in the entry for Provisional Approval.

**FMV** -- Fair Market Value, the value of the loan as determined by the
private partner in the Joint Venture. The fair market value is the
discounted amount relative to the Broker's Price Opinion.

**Holdout loans** -- a set of comparison loans that are similar to the
set of eligible loans from which ACD loans are drawn. A 10 percent
random sample of provisionally approved loans is set aside each month
before the participating servicer selects loans for ACD treatment. The
holdout loans cannot be submitted for ACD under the current or
subsequent joint ventures.

**Homeownership Retention** -- loan restructuring or loss mitigation
such that the borrower remains in his or her home. In standard FHA
processing, the loss mitigation techniques of special forbearance, loan
modification and partial claim are the three versions of loss mitigation
homeownership retention. Non-homeownership retention means the loan is
terminated -- for example, through a preforeclosure sale or
deed-in-lieu. In JV processing, homeownership retention is more
difficult to track because the loan is often sold in a note sale. It is
assumed that the borrower retains her home in a note sale, particularly
in securitization sales because the loans are performing, but there is
no information available on the retention after the sale.

**Interim PIF** -- Interim Paid In Full. Loans that are paid in full
during the transition from FHA to the JV are considered ACD loans, but
the payment does not actually reflect JV servicing. In JV2004 and later
JVs, the interim PIFs paid prior to the 4^th^ business day after the
settlement date are treated as repurchases, i.e., the full payment goes
to FHA. Loans paid on or after the 4^th^ business day following
settlement, but before the loan is transferred to the LLC servicer, are
also considered interim PIFs. However, the payment for these later PIFs
are treated like other note sales in that FHA gets 40 percent of the
recovery. For this report, all interim PIFs are categorized as PIFs.

**JV** -- Joint Venture. FHA enters a public/private joint venture in
which the private partner is responsible for managing the asset
disposition of delinquent loans. The Joint Ventures are distinguished by
the year in which the auction was conducted.

**JV2002** -- The Joint Venture begun in 2002 and managed by Citigroup.
FHA's ownership share is 30 percent. To arrive at the fair market value,
the average discount on loans relative to BPO was 37.7 percent.

**JV2003** -- Joint Venture begun in 2003 and managed by Lehman. FHA's
ownership share is 30 percent. To arrive at the fair market value, the
average discount on loans relative to BPO was 29.3 percent.

**JV2004** -- Joint Venture begun in 2004 and managed by Citigroup.
FHA's ownership share is 40 percent. To arrive at the fair market value,
the average discount on loans relative to BPO was 19 percent.

**JV processing** -- The alternative to standard FHA processing is JV
processing, in which the joint venture services the original loan,
restructures the loan or forecloses on the loan and sells the property.
The joint venture is not restricted by the same servicing rules as
standard processing, which means the loan can be sold as a discounted
note, with or without restructuring.

**Liquidation** -- the final termination of a loan, either as a sale
(note sale or property sale) or as Paid in Full (PIF).

**Loss Mitigation** -- techniques used by FHA servicers to help
delinquent loans cure their default or reinstate. The homeownership
retention loss mitigation tools are: special forbearance, loan
modification, and partial claim. The non-homeownership retention loss
mitigation tools are: preforeclosure sale and deed-in-lieu of
foreclosure. JV servicers have a wider range of loss mitigation
techniques, often referred to as loan restructuring.

**Loss Rate** -- The ratio of claims less net recovery to unpaid
principal balance. Claims are the total accelerated claim, including
participation fee, paid to the participating servicer in order for FHA
to obtain the loan. For JV2002 and JV2003, net recovery is 70 percent of
the Fair Market Value plus 30 percent of the note or property sale plus
other income less other expenses. In JV2004, the ownership share for FHA
increased to 40 percent, so the net recovery is 60 percent of the Fair
Market Value plus 40 percent of the note or property sale plus other
income less other expenses.

**LTV** - Loan-to-Value is the ratio of unpaid principal balance to
property value, based on either the BPO or the original appraisal.

**Non-Foreclosure Final Status** -- Loans that reached a final status
but did not complete foreclosure. For ACD loans, the loans in this
category are note sales sold below the unpaid principal balance. For
non-ACD loans, this category includes preforeclosure sales, deed-in-lieu
of foreclosure dispositions and any other termination involving a
partial claim.

**Note Sale** -- the Joint Ventures have the option of selling loans
either at full value or at a discount relative to the unpaid principal
balance. The note sale could be a pool sale or a securitization sale.
Only the Joint Ventures have done note sales during the ACD
Demonstration. FHA has done single family note sales in the past, but
has not done any note sales during the ACD Demonstration.

**P-servicers** -- Participating Servicers, mortgage servicers who
agreed to participate in the Accelerated Claims Disposition
Demonstration. The p-servicers send delinquent loans for provisional
approval and select which loans are ultimately submitted for accelerated
claim. The p-servicers also collect a participation fee to offset the
added costs of participation in the ACD Demonstration.

**PIF** -- Paid in Full, loans that are terminated with full payment,
usually by the borrower. In the 2^nd^ Interim Report, the PIF category
included note sales at or above par, i.e., note sales in which the
amount paid was at least as much as the UPB at settlement. However, this
expansion in the PIF designation was considered too confusing, so in the
3^rd^ Interim Report we revert to the more conventional designation of
PIF as loans paid off and all the note sales are included in the
non-foreclosure final status category.

**Property Sale** -- sale of foreclosed properties after the title has
been conveyed to HUD or the Joint Venture.

**Provisional Approval** -- the criteria used to determine which
delinquent loans are eligible for accelerated claims and joint venture
processing. To be provisionally approved a loan must meet the following
criteria:

-   Serviced by a Participating Servicer

-   Unpaid principal balance no less than \$20,000

-   Loan must be four full payments past due (5 payments starting with
    JV2005)

-   Loan-to-value (LTV) ratio of 85 percent or higher

-   P-servicer used reasonable judgment to conclude loss mitigation
    would not be successful

-   Freddie Mac EarlyIndicator Risk Grade of D, E or F

-   Mortgaged property not subject to Department of Justice seizure
    order or in an Asset Control Area

-   Mortgaged property has not sustained more than 10 percent damage
    regardless of insurance

-   Loan not subject to partial claim or special forbearance relief

-   Loan not accepted for preforeclosure sale or deed-in-lieu of
    foreclosure

-   No contested foreclosure and no foreclosure sale has been scheduled
    within 60 days

-   (Added for JV2005) For mortgage loans in bankruptcy, the mortgagor
    is not current under the terms of a confirmed repayment plan under
    Chapter 13.

There is also a maximum number of missed payments that varies by state,
ranging from 5 to 13 months. For ACD loans, the participating servicer
must order a Broker's Price Opinion (BPO) report and submit the Monthly
Supplemental Defaulted Loan Payment History. The provisional approval
lasts 60 days.

**Recovery Rate** -- the ratio of the sale price less net expenses to
the claim amount. In this report, the recovery rate is the net recovery
rate relative to claims. FHA recovery rates are the loss amount
subtracted from the acquisition cost divided by the acquisition cost.
The recovery rate differs from the loss rate in two ways. The recovery
rate is net recovery relative to claims, whereas the loss rate is
relative to UPB. Also, the recovery rate is calculated for sales, either
property sales or note sales. Loss rates are calculated as claims minus
net recovery and includes all resolutions, even cases with zero claims.

**Reinstatement** -- sufficient payment by the borrower to bring a
delinquent loan current. There is no presumption that reinstatement
loans will not default again.

**REO inventory** -- Real Estate Owned, property owned by either FHA or
the Joint Venture and waiting to be sold. REO Sale is the loan category
for REO properties after the sale.

**Standard processing** (or standard FHA processing) -- Under current
FHA rules, the servicer collects payments and forwards the premium to
FHA. Delinquent loans are given loss mitigation treatment, either using
retention tools (special forbearance, loan modification or partial
claim) or non-retention tools (preforeclosure sale or deed-in-lieu of
foreclosure). If loss mitigation fails, the servicer proceeds with
foreclosure. Upon completion of foreclosure, the title is delivered to
FHA in exchange for a claim payment and the property is sold by
Management and Marketing (M&M) contractors for HUD.

**UPB** -- unpaid principal balance, the amount of principal owed on the
loan. For ACD cases, the UPB is recorded when the loan enters the Joint
Venture. For non-ACD loans, the UPB is updated monthly and represents
the amount at the cutoff date, or August 31, 2004, used in the analysis
for this report.

[]{#__RefHeading___Toc127848904 .anchor}Background on the ACD
Demonstration Design and JV Processing

The Accelerated Claims Disposition Demonstration comes from Section 601
of the Department of Veterans Affairs and Housing and Urban Development,
and Independent Agencies Act, 1999. The Act allows the Federal Housing
Administration (FHA) additional flexibility to choose the most cost
effective methods for paying claims and disposing of foreclosed,
single-family properties. It specifically authorizes FHA to take
assignment of mortgage notes and transfer them to private partners for
servicing, property management and asset disposition. Section 601(d)
amends Section 204(g) of the National Housing Act to allow for
structured financing such that FHA retains an equity interest in the
partnership undertaking the asset disposition.

The purpose of the 601 Evaluation is to answer the following questions:

-   What is the return to HUD from the JV structure compared to standard
    HUD processing? What explains the difference in cost? How have the
    increased use of loss mitigation and evolving performance of
    Management & Marketing (M&M) contractors affected the differences?

-   How has the design of the ACD Demonstration affected the outcomes?
    Which incentive systems were productive? Which were
    counterproductive?

-   Are the outcomes compatible with FHA's policy objectives?

-   Are there alternative structures that would have improved the
    outcomes?

-   What are the implications of the ACD Demonstration outcomes for
    expansion of the program?

-   To what extent are the results seen in the Demonstration predictive
    of servicer behavior on a larger-scale?

-   What should be the next steps? Should the ACD Demonstration be
    expanded, changed or rejected altogether?

Not all of these questions are addressed definitively in this report
because the final outcomes for many ACD loans and most FHA comparison
loans have not happened yet. Nevertheless, the major patterns are
becoming clearer. For ACD to reduce costs to FHA, the p-servicers will
have to improve targeting to high-risk loans and reduce the discount on
loans sold to the JV. Even under those conditions, a strong housing
market could make the FHA claims rate from delinquencies so low that it
is extremely difficult for ACD loss rates to fall below FHA loss rates.
The focus of this report is to present the facts based on data through
August 31, 2005. The implications of those facts remain tentative while
we await final loan outcomes and more complete analysis.

[]{#__RefHeading___Toc127848905 .anchor}How ACD Works

The selection of loans under the ACD Demonstration starts with the
participating servicers (p-servicers) of FHA loans who have agreed to
submit their delinquent loans to FHA for provisional approval. There are
a number of eligibility criteria, including:

-   Serviced by a Participating Servicer

-   Unpaid principal balance (UPB) no less than \$20,000

-   Loan must be four full payments past due (increased to five payments
    for JV2005)

-   Loan-to-value (LTV) ratio of 85 percent or higher

-   P-servicer used reasonable judgment to conclude loss mitigation
    would not be successful

-   Freddie Mac EarlyIndicator Risk Grade of D, E or F

-   Mortgaged property not subject to Dept. of Justice seizure order or
    in Asset Control Area

-   Mortgaged property has not sustained more than 10 percent damage
    regardless of insurance

-   Loan not subject to partial claim or special forbearance relief

-   Loan not accepted for preforeclosure sale or deed-in-lieu of
    foreclosure

-   No contested foreclosure and no foreclosure sale has been scheduled
    within 60 days.

-   (Added for JV2005) if a bankruptcy loan, it is not current under the
    Ch.13 repayment plan.

Loans that meet the eligibility requirements are divided into two
groups, the holdout loans and the eligible loans. The holdout loans are
a 10 percent random sample of the provisionally approved loans. The
holdout loans are set aside to create a comparison cohort for the
evaluation of the ACD loans selected by p-servicers from the
provisionally approved loans. From an experimental design point of view,
it would have been better for holdout loans to be randomly drawn after
p-servicers selected loans for ACD. If the holdouts had been a random
subset of the loans selected for ACD treatment but not given JV
processing, then it would be clear that the differences in outcomes
between holdouts and ACD were due to the JV processing. However, that
would have required larger sampling rates from the provisionally
approved loans to reach statistically meaningful sample sizes of ACD and
holdouts. Instead, HUD chose a sequential design whereby the p-servicer
first selected loans for provisional approval, a 10 percent random
sample of the approved loans was set aside as the holdout sample, then
the p-servicers selected the loans for ACD from the remaining approved
loans. In the sequential design, the comparison between ACD and holdout
loans is a combination of the p-servicer selection effect and the JV
processing effect.

All three groups, ACD, holdouts and eligibles, have passed through the
provisional approval screen, but the order of selection after that
screening is potentially important. The holdouts are the first to be
drawn from the provisionally approved, so the distribution of
characteristics for holdouts should be most representative of the larger
set of provisionally approved loans. The ACD loans are then selected
from the provisionally approved excluding the holdouts. The assumption
is that foreclosure is expensive for the p-servicers as well as for FHA,
so the p-servicers have an incentive to select the high-risk loans from
the approved cases. The approval lasts for 60 days and it is certainly
possible that new information becomes available to the p-servicer that
was not known at provisional approval. It is also likely that the
p-servicer has more information, such as credit scores or the borrower's
employment history, which is used in the selection process but not
reported to HUD. Unfortunately, we know relatively little about how the
p-servicers select loans for ACD, but selection models reported in the
2^nd^ Interim Report show substantial differences among the p-servicers.
Some p-servicers target the highest risk loans before submitting for
provisional approval. Whereas, other p-servicers submit nearly all their
delinquencies, and subsequently pick the highest risk loans for ACD from
the provisionally approved cases. Under either approach, it is
apparently quite difficult to identify which delinquent loans are most
likely to go to foreclosure.

After the holdouts and ACD are selected, the remaining set of
provisionally approved loans are the eligible loans. If the high-risk
loans are selected for ACD, we would expect the eligible loans to be
lower risk than the ACD loans on average. However, the pool of eligible
loans is quite dynamic with new approvals being added each month and
continuing eligibles being drawn off to holdouts, JV2002 or subsequent
JVs. In that respect, the eligible loans are not a well-defined cohort
of loans and yet, the characteristics and outcomes of the eligible loans
are not that different from ACD or holdouts. Given our limited knowledge
about the selection process for ACD and to get a more complete view of
all the provisionally approved loans, we report results for all three
loan groups.

From the set of eligible loans, the p-servicers select a subset of loans
for accelerated claim paid by FHA. The loans submitted for ACD claim
must have a Broker's Price Opinion (BPO), but the holdouts do not. At
settlement, the ACD loans are transferred from the p-servicers to the
Joint Venture. The value of the loan as it enters the JV is based on the
accepted bid for the risk category containing the loan. The risk
categories are based on UPB or BPO, LTV and days in foreclosure.
High-risk loans are discounted more than low-risk loans, though ACD
loans as a group are relatively high risk because they are all at least
90-day delinquent loans (4 payments past due; 5 payments past due for
JV2005) and many have defaulted more than once.

JV2002 was the first joint venture, and there was considerable
uncertainty about how the process would work and how successful the JV
partner, Citigroup, would be. The average discount rate, measured as the
ratio of BPO minus the fair market value (FMV) relative to BPO, was 37.7
percent, though the discount rate for any particular risk category could
be much higher or lower than that average. JV2002 began taking in loans
in October 2002 and now contains 6,656 loans from the Philadelphia and
Atlanta Homeownership Centers (HOC). The final settlement date for
JV2002 was September 15, 2003. By the second Joint Venture, there were
several competitive bids and the winning bid to Lehman resulted in a
discount rate of 29.3 percent. JV2003 began in August 2003 and has 6,153
loans from all four HOC regions as of August 31, 2005. The final month
of settlement for JV2003 was September 15, 2004. In both JVs, HUD has a
30 percent ownership share and the private partner has a 70 percent
share. When the loan is transferred to the JV, the private partner pays
FHA 70 percent of the FMV.

The Demonstration continues with JV2004, won by Citigroup again. The
major change in the third joint venture is that the discount, or rate at
which JV buys the loans from FHA, has declined substantially to 19
percent. The smaller discounts show that private partners recognize the
value contained in FHA delinquent loans and have overcome their
uncertainty about the ACD Program. Another sign of confidence in the
profitability of the joint ventures is that FHA has increased its
ownership share from 30 percent in JV2002 and JV2003 to 40 percent in
JV2004. The reduction in discounts and increase in ownership share
should increase the recovery rate that FHA obtains from the latest joint
venture. The last settlement date for JV2004 is June 14, 2005 for a
total of 6,813 loans. Subsequent delinquent loans flow into JV2005.
Exhibit 1 shows the participating servicers for each Joint Venture.

+----------------+-----------------+-----------------+----------------+
| **Exhibit 1**  |                 |                 |                |
|                |                 |                 |                |
| *              |                 |                 |                |
| *Participating |                 |                 |                |
| Servicers by   |                 |                 |                |
| Joint          |                 |                 |                |
| Venture**      |                 |                 |                |
+----------------+-----------------+-----------------+----------------+
| **JV2002**     | **JV2003**      | **JV2004**      | **JV2005**     |
+----------------+-----------------+-----------------+----------------+
| Wells Fargo    | Wells Fargo     | Wells Fargo     | Wells Fargo    |
+----------------+-----------------+-----------------+----------------+
| Chase          | Chase           | Chase           | Chase          |
+----------------+-----------------+-----------------+----------------+
| PHH (Cendant)  | PHH (Cendant)   | Aurora          | Aurora         |
+----------------+-----------------+-----------------+----------------+
| Countryside    |                 | Washington      | Washington     |
|                |                 | Mutual          | Mutual         |
+----------------+-----------------+-----------------+----------------+
|                |                 |                 | Bank of        |
|                |                 |                 | America        |
+----------------+-----------------+-----------------+----------------+
|                |                 |                 | EverHome       |
+----------------+-----------------+-----------------+----------------+

Loans transferred from p-servicer to JV are evaluated by the private
partner to determine how best to maximize the return on the loan. Some
loans are restructured with new terms, some loans pay in full, and some
loans go to foreclosure and then REO status. In most cases, the JV
attempts to bring the loan back to performing status and then sell the
note either in a pool sale or securitization sale. Loans liquidated
through note sales generally earn a higher return than property sales,
so the JV has an incentive to maximize the share of note sales relative
to property sales. When the note or property is sold, FHA receives 30
percent of the sales price less 30 percent of the expenses for servicing
and selling the asset. FHA's percentage increased to 40 percent for
JV2004. The net recovery is the amount remaining after adjusting for
income and expenses. In this report, the recovery rate is the net
recovery amount divided by the claims amount. The loss rate is measured
as the total costs less recoveries divided by the UPB. The UPB is the
unpaid principal balance reported by the p-servicer when the loan is
submitted for provisional approval.

[]{#__RefHeading___Toc127848906 .anchor}Outcomes

The progress of the first three Joint Ventures up to August 31, 2005 is
shown in the following three exhibits. The loan status in counts of
loans is shown in Exhibit 2. Dollar values (UPB) for the same categories
of loans are displayed in Exhibit 3 and average UPB per loan are
presented in Exhibit 4. The benchmark for progress is the share of loans
that have reached resolution. For JV2002, 93 percent of ACD loans
compared to 67 percent of holdout loans have been resolved. JV2003 does
not lag far behind with 80 percent ACD loans and 56 percent holdouts
having reached resolution. The most recent JV to complete settlements,
JV2004, has only 42 percent of ACD loans and 30 percent of holdout loans
having resolved. For each JV cohort, it is clear that a higher
percentage of ACD loans have resolved than either the holdouts or
eligible loans. In a deteriorating market, quick resolution can be
important and the Joint Ventures have demonstrated that they can resolve
loans in less time than standard FHA processing.

Exhibit 2

![](media/image1.wmf){width="9.109722222222222in"
height="5.166666666666667in"}

Loan Status by Numbers of Loans (Data as of 8/31/2005)

Exhibit 2

Loan Status by Numbers of Loans (Data as of 8/31/2005) - *continued*

![](media/image2.wmf){width="5.993055555555555in"
height="3.511111111111111in"}

Exhibit 3

Loan Status by Amount of Unpaid Principal Balance
![](media/image3.wmf){width="9.040277777777778in"
height="4.827083333333333in"}(Data as of 8/31/2005)

Exhibit 4

![](media/image4.wmf){width="9.0in" height="3.38125in"}Loan Status in
Average Unpaid Principal Balance (Data as of 8/31/2005)

The loan status for each loan is classified into one of eleven
categories arranged with the three final status categories at the top
followed by various grades of interim categories. The rules used for
loan status assignment follow Exhibit 2. The ordering follows the
programming code, which gives preference to final status categories over
interim status categories.

The three final status categories are:

-   Paid In Full (PIF),

-   REO Sold and,

-   Non-foreclosure Final Status.

In the Second Interim Report, the Paid in Full (PIF) category included
not only the loans in which the borrower paid the outstanding balance
(prepays), but also the note sales for which the amount received was
greater than or equal to the UPB. Including note sales at or above par
in the PIF categorization was confusing, so in this report we revert to
the more conventional definition for paid in full when the borrower pays
the amount of the outstanding balance according to the servicer. For
JV2002, 1,527 note sales were at or above the UPB recorded at settlement
and 133 PIF cases paid less than the UPB recorded at settlement. Small
discrepancies in the UPB value between the servicer and the PeopleSoft
data may cause differences in the categorization. Using the servicer
identification of PIF resolutions, there are 925 PIF loans in JV2002 or
14 percent of 6,656 JV2002 loans.[^1] Similarly for JV2003, there are
581 PIF loans or 9 percent of 6,153 loans. Given the high risk of these
loans and the extended number of months since delinquency began, we
expect little gain in the share of PIF loans as the JVs finalize.

Another distinction in the 3^rd^ Interim Report is the explicit
inclusion of interim PIF in the PIF category. In the case of interim
PIF, the "interim" means during the transfer between the participating
servicer and the JV servicer. Interim PIF is a designation given by the
Asset Sales Office and the "interim" does not refer to the non-final
status of the loan. Identification of interim PIFs is not available in
the ACCRA or PeopleSoft data. For JV2002, there were 128 interim PIFs
and for JV2003 there were 182 interim PIFs. In JV2004, there were 110
loans that paid before the 4^th^ business day after the settlement and
another 84 that paid in between the 4^th^ business day and when the
transfer was completed to the JV or LLC servicer. The 110 interim PIFs
are treated as repurchases in that 100 percent of the payment goes to
FHA although they are still categorized as PIFs among the ACD outcomes.
The 84 interim PIFs are treated as note sales in that FHA gets 40
percent of the recovered amount. In this report, both types of interim
PIFs are categorized as PIFs.

To the extent that ACD loans are selected to be high risk of
foreclosure, the share of REO Sold resolution should be higher for ACD
than holdout loans. In all three joint ventures shown in Exhibit 2, the
percent of ACD resolutions in the REO sold category is larger than the
corresponding shares for holdouts or eligibles. For example in the 2002
cohort, JV2002 has 22 percent REO sold compared to 18 percent for
holdouts and 11 percent for eligibles. Some of the difference is likely
attributed to the faster resolution in ACD. As seen in the interim
status Foreclosure in Process, there is only 1 percent of ACD loans
compared to 10 percent of holdouts and 9 percent of eligibles that have
started foreclosure. If all those holdout loans in foreclosure
ultimately become REO sold, it is quite possible that the final share of
REO sold is lower for ACD than holdout loans.

To date, the predominant difference in disposition strategies between JV
processing[^2] and standard FHA processing is the option by the JV to
conduct note sales and securitizations. The disposition strategy for the
standard FHA processing is foreclosure and subsequent sale by HUD's M&M
contractors. Note sales are commonly done in ACD, but not done by FHA
servicers. In particular, the JV can write down or forgive a portion of
the principal as part of the loan restructuring, which FHA servicers
cannot do. As of August 31, 2005, there have been 3,776 or 57 percent of
the JV2002 loans sold as notes. Of the JV2002 notes, 2,599 were sold in
a single securitization sale in August 2004. JV2003 has had smaller
(about 600 loans per sale) and more frequent pool sales. In June 2005,
JV2004 had a whole loan sale of 1,814 reperforming loans, which accounts
for the bulk of its note sales to date.

Reinstatements of eligible and holdout loans are included as resolutions
because they continue as active FHA loans making regular payments. There
is no presumption that reinstatements will remain active and current.
Rather, Exhibits 2 and 3 show the number of reinstatements as of August
31, 2005. Reinstatements of standard FHA loans are considered
resolutions because the servicer is no longer trying to change the
status of the loan, which is similar to the other final resolution
categories. ACD reinstatements (reperforming loans) are listed with the
other non-final categories because all ACD loans eventually are sold as
notes or properties. Therefore, ACD reinstatements are waiting for the
next note sale either as a pool sale or a securitization sale (see
Reinstatements Pending Sale in the interim status category).

The non-final status categories are listed below the Total Resolutions
in Exhibit 2. REO inventory and non-retention loss mitigation, are
properties waiting to be sold. The distinction is that REO inventory
completed foreclosure, while non-retention loss mitigation means the
borrower has started a preforeclosure sale or deed-in-lieu transfer. In
percentage terms, there is little difference between the ACD and non-ACD
loan groups.

All the loans in the remaining non-final status categories could recover
so that the borrower could retain the ownership of his or her home.
Under the foreclosure in process category, the foreclosure has begun but
not yet completed. A significant share of non-ACD loans (about 10
percent in the 2002 and 2003 cohorts) compared to only 1 or 2 percent of
the ACD loans have begun foreclosure. It is likely that this reflects a
difference in timing. In the 2004 cohort, about 30 percent of the
non-ACD loans are in the process of foreclosure compared to 21 percent
of ACD loans.

Standard FHA servicing appears to give the borrower more time as they
attempt to reinstate the loan through loss mitigation strategies. The JV
servicer has a broader set of loss mitigation options, including
restructuring the loan with a loan amount below the original UPB. If the
JV servicer determines that the borrower will not be able to make
payments, the appropriate loss mitigation alternatives are explored with
the borrower including, but not limited to, short sales or deed-in-lieu
of foreclosure. Moving promptly to foreclosure should only be considered
after all non-foreclosure alternatives have been considered. In the
original concept for ACD, the p-servicers were expected to submit loans
for ACD that would not benefit from loss mitigation treatment because
those loans had such a high probability of going to foreclosure.
Although few of the JV2002 loans are still getting loss mitigation
treatment, 3 percent of JV2003 and 8 percent of JV2004 loans are getting
some form of retention loss mitigation. Given the substantial share of
ACD note sales, it appears that the JV servicer considers the loss
mitigation servicing to be worthwhile.

The bright spot for standard FHA processing is that a substantial
portion of their loans are reinstating, 18 percent of holdouts and 23
percent of eligible loans compared to only 0.3 percent for JV2002 (shown
as the fourth category among the Interim Resolutions). Most of the ACD
loans that reinstate have already been sold in the note sales and thus
grouped in the PIF or non-foreclosure final status. The same pattern
appears in 2003 with 17 percent of holdouts and 20 percent of eligibles
reinstated compared to 4 percent of JV2003 loans waiting for the next
note sale. The low rate of ACD reinstatement is offset by the high rate
of PIF and discounted note sales relative to standard FHA processing. In
fact, many of the ACD note sales may be reinstated loans such that the
only difference from the borrower's point of view is the termination of
FHA mortgage insurance on the note. For example, using the standard of
"3 payments in 3 months," we found that 35 percent of the JV2002 loans
were performing in the 3 months prior to August 2004. Those loans were
sold in a securitization sale in August. It suggests that the rate of
reinstatement may be as high among ACD loans as standard FHA processing,
though the reinstatement status is preempted by the note sales
(non-foreclosure final status).

The high rate of reinstatement for both ACD and FHA is notable because
all of these loans were considered a high risk of claim by the
p-servicers. Favorable housing market conditions with rising house
values and low interest rates get credit for much of this success.
Another factor in the high rate of reinstatement is the apparent
difficulty for p-servicers in selecting high-risk cases. At the time of
provisional approval, all of the loans had Early Indicator grades of D,
E or F, which means they are likely to foreclose and claim without
aggressive intervention. The fact that so many loans re-performed under
ACD could be a testament to the superior servicing under JV. Yet, a
large share of holdout and eligible loans also reinstated without JV
processing. There appears to be a "trough" phenomenon, whereby loans are
selected at provisional approval when borrower income and payments have
dropped to a low point. Many of those loans will recover under standard
FHA servicing as borrower income and payments are restored. The
challenge is to determine which loans will not recover. The high rate of
reperformance under JV processing or reinstatement under FHA processing
shows that it is quite difficult to predict ultimate foreclosure and
claims.

The Loan Status by amount of UPB is shown in Exhibit 3. The results are
quite similar to the percentages based on numbers of loans in Exhibit 2.
The percentage of loans with Paid In Full (PIF) status is larger in
terms of UPB suggesting that loans with above average UPB are more
likely to pay off or prepay. On the other hand, the share reinstating
under standard processing is slightly smaller in terms of UPB than for
numbers of loans, suggesting the smaller value loans are more likely to
reinstate.

Loan Status in average UPB is presented in Exhibit 4. Overall, the 2003
averages are larger in part because the loans originated more recently.
Another reason the 2003 loan values are higher is that they are drawn
from all four Homeownership Centers, including the West Coast where
house values are substantially higher. A consistent pattern for both
loan cohorts is that average UPB for REO sales is about 70 to 90 percent
of the UPB for PIF. Similarly, REO inventory and, to a lesser extent,
foreclosure in process loans tend to be below average of UPB.

[]{#__RefHeading___Toc127848907 .anchor}Homeownership Retention

Homeownership retention is an important goal for FHA and one concern
about the ACD program is that faster processing could push more
borrowers out of their homes. Unfortunately, the data is truncated to
the extent that we do not know the homeownership retention status after
the note sale. In the short run, every note sale counts as homeownership
retention. The JV2002 securitization sale in August included 2,599
performing loans. The holder of the note changed hands, but the borrower
kept her home and continues with monthly payments. All those note sales
should count as homeownership retention. For whole loan sales, the
servicing is transferred and no further information is available.

A simple approach is to count all the cases that are not REO (either REO
sold or REO inventory) as possible homeownership retentions, as shown in
Exhibit 5. By that measure in 2002, 74.8 percent of ACD and 78.5 percent
of the holdouts could retain their homes. The same pattern holds for
2003, 67.6 percent retention for ACD vs. 76.4 percent retention for
holdouts. In the latest ACD cohort, JV2004, 84.7 percent of the loans
could retain their homes compared to 91.3 percent of the holdouts. The
sample sizes for eligible loans are considerably larger and support the
finding that standard FHA processing is better at avoiding REO, at least
in the short run.

**Exhibit 5**

![](media/image5.wmf){width="5.997222222222222in" height="2.8625in"}

**Homeownership Retention Rates** (Data as of 8/31/2005)

If we include foreclosure with REO, on the presumption that most
foreclosures end in REO inventory, ACD has higher homeownership
retention than holdouts in 2002 (73.6 percent vs. 68.9 percent) but the
same in 2003 (65.7 percent for ACD vs. 65.6 percent for holdouts).
However, the comparison of ACD with holdouts in 2004 or with eligibles
for any year shows higher retention for standard processing. Note,
eligibles are not a good comparison group for homeownership retention
because the more advanced foreclosure cases have been selected out of
the eligibles for subsequent ACD. Given the limited data, it appears
that standard FHA processing has a small advantage in homeownership
retention, at least in the short run.

Some ACD loans are further advanced in the foreclosure process when they
are sold to the JV and JV processing through note sales is faster at
reaching final resolution than standard FHA processing through REO
sales. Therefore, much of the short run difference in homeownership
retention may simply be due to faster processing by JV than FHA. As the
ACD loans reach final status, the long run homeownership retention can
be more reliably measured at that time.

[]{#__RefHeading___Toc127848908 .anchor}Costs and Recoveries

The financial outcomes for the 2002 to 2004 loan groups are presented in
Exhibits 6, 7 and 8 respectively. The values are as of August 31, 2005.
For ACD, eligibles and holdouts, the top three panels show outcome
counts, unpaid principal balances and claims costs to HUD by outcome
category. The fourth panel shows net recovery rates relative to claims
and the fifth panel shows the loss rates relative to UPB. An important
issue in comparing rates, for example between ACD and holdouts, is
whether the reinstatements and partial claims are included. The
reinstatements have very low claims relative to foreclosures and no
recovery because there is no sale. Therefore including reinstatements in
the loss rate greatly reduces the loss rate from what it would be just
considering REO sales.

As shown in the ACD column of Exhibit 6, JV2002 has 6,656 loans with a
total value of \$609 million and total claims cost to HUD of \$643
million. Those totals are unchanged from the 2^nd^ Interim Report. What
has progressed is the share of resolutions. With 93 percent in final
status, we have more confidence that the final results will be similar
to the results reported in Exhibit 6. Even if all remaining loans end in
REO sale, the share of REO will be under 30 percent, which is much lower
than the 40 percent foreclosure rate assumed before the demonstration
began. The claims cost is 106 percent of UPB and quite consistent by
outcome. In comparison, the claims cost ranges from essentially zero for
PIF to 116 percent REO. The lower claims cost of JV loans is a key
source of the expected savings for the ACD Program. Combining final
resolutions for the holdout loans, the claims cost rate for holdouts is
28 percent, which is much lower than ACD's 106 percent because all ACD
loans start with an accelerated claim to the p-servicer.

The net recovery measures the sales amounts net of costs relative to the
claim amount. All ACD loans are ultimately sold as either notes or
properties, so all ACD final resolutions are included in the net
recovery rate. For JV2002, the recovery rate ranges from a high of 78
percent for PIF to a low of 57 percent for property sales. The largest
share of loans end as note sales with a recovery rate of 71 percent. The
overall recovery rate for JV2002 is 69 percent. Only REO properties have
recoveries from sale of the holdout loans. The recovery rate is 67
percent of REO claims and 65 percent of total claims for final
resolutions. Clearly, ACD loans have a higher recovery rate relative to
the FHA foreclosures.

The bottom panel of Exhibit 6 shows the loss rates relative to claims.
Even though the loss rates are highest for REO sales (45 percent), most
of the outcomes are note sales with a loss rate of 31 percent. The
overall loss rate for resolved loans in JV2002 is 33 percent. By
comparison, the loss rate for REO holdout loans is 38 percent of claims
and 10 percent overall. The large drop in loss rates is due to the very
low losses in PIF and reinstated loans. Nearly half of the holdouts
resolved into categories with very low losses. The unexpectedly high
rate of PIFs and reinstatements among holdouts make it difficult for ACD
to have a lower loss rate than the control group. It is likely that the
difference between the 33 and 10 percent loss rates will narrow,
particularly if many holdouts end in REO sales. However, it is highly
unlikely that the JV2002 loss rates will ultimately be less than the
loss rates for standard FHA processing.

The JV2003 loans follow a similar pattern as JV2002 though fewer loans
have reached final resolution. See Exhibit 7. The claims costs are lower
(105 percent for JV2003 and 111 percent for REO holdouts). The net
recovery rates for JV2003 are 6 to 11 percentage points higher than
JV2002, which probably reflects the national coverage of JV2003
including California. The higher recoveries are enough for JV2003 REO
loss rates (34 percent) to dip below REO holdout loss rates (36
percent). However, as with JV2002, when the comparison of loss rates
includes all final resolutions, the JV2003 loss rate of 26 percent is
much higher than the 12 percent loss rate for standard FHA processing of
the holdouts.

The JV2004 loans have more limited resolutions (42 percent). Although
the claims cost is 109 percent (higher than the other JVs and higher
than REO holdouts in the 2004 cohort), the net recovery rate is also
higher. Essentially the REO loans have about the same recovery rates and
loss rates for ACD, eligibles or holdouts. The higher recoveries and
lower losses from PIF and note sales of JV loans is not enough to offset
the near zero losses from reinstatements of holdout loans. In terms of
final resolutions, the 24 percent loss rate for JV2004 is much higher
than the 3 percent loss rates for holdouts. However, the 2004 cohort is
relatively young and these results are likely to change as more loans
reach final resolution.

Focusing on just the REO sales, Exhibit 9 shows the costs and recoveries
from REO sales by each loan cohort. The most distinct separation between
ACD and holdouts are the recovery rates for 2002. Relative to UPB, the
recovery rate of REO properties is 60.3 percent for ACD and 77.8 percent
for holdouts. The emphasis in JV2002 is on note sales and especially the
large securitization. The quality of properties that go through
foreclosure is apparently quite low. The recovery rate relative to
claims presents a smaller differential (57.1 percent for ACD vs. 67.2
percent for ACD) due to the higher claims costs for holdout loans.

For the 2003 cohort, the recovery rates relative to UPB are much closer
together (71.3 percent for ACD vs. 74.3 percent for holdouts). Again,
the high claims costs for the holdouts reduce the holdout recovery rate
relative to claims so that the recovery rates are essentially equal
(67.8 percent for ACD vs. 67.1 percent for holdouts).

**Exhibit 6**

![](media/image6.wmf){width="5.240277777777778in" height="7.05in"}

**Financial Outcomes of the 2002 Loans** (Data as of 8/31/2005)

**Exhibit 7**

![](media/image7.wmf){width="5.770138888888889in"
height="7.7555555555555555in"}(Data as of 8/31/2005)

**Exhibit 8**

![](media/image8.wmf){width="5.55in" height="7.465972222222222in"}(Data
as of 8/31/2005)

ACD recovery rates for the 2004 cohort have started out at a relatively
high level (77.1 percent for JV2004 compared to 71.3 percent for JV2003
and 60.3 percent for JV2002). It appears that the better properties sell
first because the recovery rate declines over time. For example, the
recovery rate relative to UPB for JV2002 reported in the 2^nd^ Interim
Report was 63.2 percent and a year later it has slipped to 60.3 percent.
Similarly for JV2003, the recovery rate last year was 74.0 percent
compared to 71.3 percent this year. The decline for the holdouts of 2003
is even greater (80.3 percent vs. 74.3 percent) though the sample size
of holdout REOs was only 88 properties last year. The sample size for
REO holdouts in the 2004 cohort is only 81 properties, so that recovery
rate is likely to change.

An alternative view about the decline in recovery rates is shown in
Exhibit 10. This table shows the recovery rates relative to claims
broken down by homeownership center along with the national summary. The
three cohorts are compared to the official FHA recovery rates for the 12
months through August 2004 and the 12 months through August 2005. The
main point is that FHA recovery rates have declined between 2004 and
2005. Independent of ACD or any selection effect as the cohort ages, the
overall FHA recovery rates are slipping and the declines are most
notable in Philadelphia (-3.1 points) and Atlanta HOCs (-1.4 points). So
far, JV2004 has a relatively high share of property sales in the Atlanta
HOC compared to the 2003 cohort. Sample sizes for 2004 are modest. The
distribution of property sales by HOC as well as national trends in
recovery rates will influence the future trend in recovery rates. Weaker
housing markets are likely to lead to lower recovery rates for ACD and
holdouts alike.

[]{#__RefHeading___Toc127848909 .anchor}Claims Model

By this point in the evaluation, it is clear that the challenge for the
ACD Demonstration is selecting the loans that are highly likely to go to
foreclosure and then converting those loans to note sales. Although that
is the intention and expectation that most loans chosen for ACD will
foreclose, less than 30 percent of the delinquent loans with provisional
approval are going to foreclosure. FHA could save money on the REO sale
cases by using ACD. The problem is that FHA loses money on the non-REO
cases and most of the loans have non-REO resolutions.

Reducing the discount at which the loans are sold to the JV will help.
Another positive change is increasing the ownership share in the JV,
which helps when the housing market is strong enough to absorb
reperforming notes and REO properties. However, it is possible that the
JV will show it best advantage in a weakening housing market when speed
of disposition matters most. Those "soft" markets are riskier and FHA
may want a smaller ownership share to mitigate risk. Ultimately, the
critical factor is limiting the ACD loans to cases that are highly
likely to foreclose.

The challenge is to find the combination of loan selection criteria, JV
discount rate, FHA ownership share and a housing market environment in
which ACD can save FHA money -- at least most of the time. We have
accumulated some experience in variation of JV discounts and FHA
ownership shares. The housing markets have been generally strong owing
to low interest rates, but there is some variation among the states and
rising interest rates may weaken select markets further. Also, JV2005
has implemented new rules on loan selection such that a loan must be at
least 5 months delinquent before it is accepted for ACD. It is too soon
to tell whether that limitation will be sufficient.

**Exhibit 9**

![](media/image9.wmf){width="9.05in" height="5.277083333333334in"}

**Costs and Recoveries to HUD from REO Sales** (Data as of 8/31/2005)

**Exhibit 10**

![](media/image10.wmf){width="6.943700787401575in"
height="2.2098425196850395in"}![](media/image11.wmf){width="2.010236220472441in"
height="2.091732283464567in"}**HUD's RE O Sale Net Recovery Rates
Relative to Claims by Homeownership Center** (Data as of 8/31/2005)

Nevertheless, there is enough data to experiment with simulations to see
if high-risk loans and low JV discount rates can be combined with FHA
ownership shares and housing markets to make ACD worthwhile.

The first step is to model claims under standard FHA processing. The
claims model essentially measures risk based on the probability of a
loan ending in foreclosure.[^3] The data come from FHA loans that became
delinquent in 2001 and would have been provisionally approved (had ACD
existed in 2001). The prediction of the claims model is a probability of
conveyance claim given what was known at delinquency. That prediction
can be used as a risk score. And the model coefficients can be applied
to any set of loans to predict the likelihood of claim under FHA
processing.

The predicted risk score can be used in several ways. The simplest use
is to aggregate the loan scores to measure and compare the portfolios of
loans by risk. If the p-servicers are picking out the high-risk loans
for ACD, then the risk score for the JV portfolio should be
substantially higher than the risk score for the holdout portfolio from
the same time. Even if the ACD vs. holdout risk scores start out
relatively close together in 2002, is there a trend to show a greater
distinction by the 2004 cohort? Suppose the selection criteria for ACD
loans were tightened to include just the high-risk loans. Would the
share of foreclosures for this high-risk set of loans be high enough
that ACD has lower loss rates than they would have had under standard
FHA processing?

These experiments in loan selection can be combined with a simulation of
different JV discount rates, FHA ownership shares and state housing
markets to see how far the program parameters would have to change to
make ACD cost saving. Given unexpected difficulties with the JV2004
data, we have not had much time to carry out the simulations. However,
we can report estimates from the claims model and show exploratory
simulations.

[]{#__RefHeading___Toc127848910 .anchor}Claims Model Estimation

In the 2^nd^ Interim Report, we estimated a claims model using the 1997
cohort of delinquents. We were concerned that the FHA processing was
substantially different in the early phases of loss mitigation and M&M
contractors. Therefore, in this report we have shifted to a 2001 cohort
of delinquents with more parallel experience compared to the current
cohort of ACD loans. As shown in Exhibit 11 for 2001, the only drawback
of the 2001 cohort is that slightly more loans have not terminated (27.2
percent for 2001 vs. 23.4 percent for 1997). Relative to the
terminations, only 42.0 percent ended in conveyance claim and 44.5
percent (not shown in Exhibit 11) had any claim in the 2001 cohort
compared to 63 percent in 1997. Also, fewer reinstatements claims (11.8
percent in 2001 vs. 14.8 percent in 1997), but more loss mitigation
cases claimed (10.2 percent in 2001 vs. 2.9 percent in 1997). Overall,
it appears the 2001 cohort is less prone to claim than the 1997 cohort.

**Exhibit 11**

**Final Status of Eligible Loans in 2001** (Data as of 8/31/2005)

![](media/image12.wmf){width="6.729861111111111in"
height="2.088888888888889in"}

The claims model is a multinomial logit model with two outcomes relative
to active, non-conveyance claim terminations and conveyance claim
terminations. See Exhibit 12. The specification is essentially the same
as estimated in the last report. Fixed effects are included for servicer
(Wells is the reference) and state (Illinois is the reference). Loans
with LTV above 97 percent are particularly likely to foreclose. Also,
loans in MSAs with a high default rate in previous years are more likely
to default.

To test the claims model, we compare the predicted conveyance claim rate
for holdouts to the actual conveyance claim rate, shown in Exhibit 13.
In 2002, the predicted claim rate is 22.0 vs. 21.21 percent actual. In
2003, the prediction is 23.2 percent compared to 23.45 percent. The
model did not work well for 2004 (22.2 percent predicted vs. 8.26
percent actual), but the 2004 cohort is so recent that most of the
foreclosures have not been completed yet.

Assuming the claims model predictions are fairly reliable, the
difference between the predicted claims rate and the actual JV REO sales
rate is the improvement due to JV servicing. The predictions use the
coefficients from the claims model, but the data come from the JV loans
at provisional approval. In JV2002, the predicted conveyance claim is
25.4 percent compared to actual JV2002 REO sales of 22 percent (see
Exhibit 2). This finding implies that JV servicing can reduce the REO
share by 3 percentage points. Similarly for JV2003, the predicted claim
rate is 27.1 percent compared to the actual of 25 percent REO sales, a
gain of 2 percentage points. Though small, these gains are important
because converting foreclosures to note sales is one way ACD can reduce
the loss rate.

[]{.mark}

Although there are modest reductions in the property sale rate by ACD,
Exhibit 14 shows that most of those reductions occur in the low-risk
loans. The JV2002 loans are sorted from low risk to high risk based on
the predicted probability of conveyance claim by the claims model.

**Exhibit 12**

![](media/image13.wmf){width="5.996456692913386in"
height="4.480708661417323in"}![](media/image14.wmf){width="5.996456692913386in"
height="3.5255905511811023in"}

**Claims Model Using Eligible Loans in 2001** (Data as of 8/31/2005)

**Exhibit 12**

**Claims Model using Eligible Loans in 2001** (Data as of 8/31/2005) -
*continued*

![](media/image15.wmf){width="5.996527777777778in"
height="4.004166666666666in"}

The ACD solid line shows the actual property sale rate by decile and the
dotted counterfactual line shows the predicted conveyance claim rate for
the same loans had they gone to standard FHA processing. The main point
is that the curves are close together, which suggests very little
difference in the actual outcome relative to the predicted outcome.
Where there is a consistent gap, however, the risk of foreclosure is
relatively low. This finding makes sense. The ACD loans most likely to
be sold as notes are the low-risk ACD loans. It is worth keeping this in
mind when we consider targeting of ACD to high-risk loans. While it is
true that ACD generally has lower losses on the REO sales than FHA REO
sales, there may be less opportunity for the bigger savings of
converting those foreclosures into note sales.

Exhibit 15 compares the actual property sale rate for JV2003 (solid
line) to the counterfactual claims rate if those same loans had received
standard FHA processing. Except for the lowest two deciles (low-risk
cases), the actual ACD curve is higher than the counterfactual. This
finding suggests that loans in JV2003 are more likely to be sold as REO
than if they had been selected as holdouts.

**Exhibit 13**

**Average Predicted Outcomes by Loan Groups and P-Servicers Using Claims
Model Estimated on 2001 Eligible Loans** (Data as of 8/31/2005)

![](media/image16.wmf){width="6.870138888888889in"
height="2.9145833333333333in"}

**Exhibit 14**

**Actual Property Sale Rate and Counterfactual Claims Rate of 2002 ACD
by Claims Rate Decile**

![](media/image17.wmf){width="5.995138888888889in"
height="2.9784722222222224in"}

![](media/image18.wmf){width="5.995138888888889in"
height="2.9784722222222224in"}**Exhibit 15**

**Actual Property Sale Rate and Counterfactual Claims Rate of 2003 ACD
by Claims Rate Decile**

[^1]: Under the approach used in the 2^nd^ Interim Report for PIFs,
    there would be 2,219 loans that paid at or above the UPB value at
    settlement as reported in the PeopleSoft data.

[^2]: The term "processing" is used in place of "servicing" because
    processing encompasses a broader range of activities including loan
    servicing, note sales and property sales.

[^3]: In the 2^nd^ Interim Report, the claims model estimated the
    probability of any claim, including loss mitigation and partial
    claims. The claims model in this report focuses on foreclosure and
    conveyance claims to emphasize the distinction between REO and
    non-REO outcomes.