National default and foreclosure rates rose sharply from 2005 through 2009 to the highest level in 29 years (fig. 1). Default rates climbed from 1.09 percent to 5.09 percent, and foreclosure start rates—representing the percentage of loans that entered the foreclosure process each quarter— grew almost threefold, from 0.42 percent to 1.2 percent. Put another way, over half a million mortgages entered the foreclosure process in the fourth quarter of 2009, compared with about 174,000 in the fourth quarter of 2005. Finally, foreclosure inventory rates rose over 350 percent over the 4-year period, increasing from 0.99 percent to 4.58 percent, with most of that growth occurring after the second quarter of 2007. As a result, over 2 million loans were in the foreclosure inventory as of the end of 2009. Foreclosure starts declined in the last quarter of 2009, but the number of defaults continued to climb. Foreclosure is a legal process that a mortgage lender initiates against a homeowner who has missed a certain number of payments. The foreclosure process has several possible outcomes but generally means that the homeowner loses the property, typically because it is sold to repay the outstanding debt or repossessed by the lender. The foreclosure process is usually governed by state law and varies widely by state. Foreclosure processes generally fall into one of two categories—judicial foreclosures, which proceed through courts, and nonjudicial foreclosures, which do not involve court proceedings. The legal fees, foregone interest, property taxes, repayment of former homeowners’ delinquent obligations, and selling expenses can make foreclosure extremely costly to lenders. Options to avoid foreclosure include forbearance plans, short sales, deeds in lieu of foreclosure, and loan modifications. With forbearance plans and loan modifications, the borrower retains ownership of the property. With short sales and deeds in lieu of foreclosure, the borrower does not. In March 2009, Treasury issued the first HAMP guidelines for modifying first lien mortgages in an effort to help homeowners avoid foreclosure. The goal of the first-lien mortgage modification program is to reduce the monthly payments of struggling homeowners to more affordable levels— specifically 31 percent of household income. According to Treasury, HAMP was intended to offer reduced monthly payments to up to 3 to 4 million homeowners. Under the first-lien modification program, Treasury shares the cost of reducing the borrower’s monthly mortgage payments with mortgage holders/investors and provides various financial incentives to servicers, borrowers, and mortgage holders/investors for loans modified under the program for 5 years. To be eligible for a first-lien loan modification: the property must be owner occupied and the borrower’s primary residence; the property must be a single-family property (1 to 4 units) with a maximum unpaid principal balance on the unmodified first-lien mortgage that is equal to or less than $729,750 for a 1-unit property; the loan must have been originated on or before January 1, 2009; and the monthly first-lien mortgage payment must be more than 31 percent of the homeowner’s gross monthly income. Borrowers have until December 31, 2012, to be accepted into the first-lien modification program. HAMP also includes other subprograms that, for example, offer incentives to modify or pay off second-lien loans of borrowers whose first mortgages were modified under HAMP and to pursue foreclosure alternatives when a HAMP modification cannot be offered. The HAMP first-lien modification program has four main features: 1. Cost sharing – Mortgage holders/investors will be required to take the first loss in reducing the borrower’s monthly payments to no more than 38 percent of the borrower’s income. Treasury will then use TARP funds to match further reductions on a dollar-for-dollar basis, down to the target of 31 percent of the borrower’s gross monthly income. The modified monthly payment is fixed for 5 years or until the loan is paid off, whichever is earlier, as long as the borrower remains in good standing with the program. After 5 years, the payment may increase by 1 percent a year to a cap of the Freddie Mac rate for 30-year fixed rate loans as of the date that the modification agreement is prepared. 2. Standardized net present value (NPV) test – The NPV test compares expected cash flows from a modified loan to the same loan with no modification. If the expected cash flow with a modification is greater than the expected cash flow without a modification, the loan servicer is required to modify the loan. According to Treasury, the NPV test increases mortgage holder/investor confidence and helps ensure that borrowers are treated consistently under the program by providing a transparent and externally derived objective standard for all loan servicers to follow. 3. Standardized waterfall – Servicers must follow a sequential modification process to reduce payments to 31 percent of gross monthly income. Servicers must first capitalize accrued interest and expenses paid to third parties. Next, interest rates must be reduced to the higher of 2 percent or a level that achieves the 31 percent debt-to- income target. If the debt-to-income ratio is still over 31 percent, servicers must then extend the amortization period of the loan up to 40 years. Finally, if the debt-to-income ratio is still over 31 percent, the servicer must forbear—defer—principal until the payment is reduced to the 31 percent target. Servicers may also forgive mortgage principal at any step of the process to achieve the target monthly payment ratio of 31 percent. 4. Incentive payment structure – Treasury will use HAMP funds to provide both one-time and ongoing (“pay-for-success”) incentives to loan servicers, mortgage holders/investors, and borrowers to increase the likelihood that the program will produce successful modifications over the long term and help cover the servicers’ and investors’ costs of modifying a loan. Prior to HAMP, many servicers offered their own loan modification programs, but the vast majority of these loan modifications increased or did not change the borrower’s monthly mortgage payment. Rather, the focus of these programs was on bringing delinquent loans current by adding past due interest, advances for taxes or insurance, and other fees to the loan balance. Some of these loan modifications changed the interest rate or remaining term of the loan but typically focused on reducing payments to 38 rather than 31 percent of the borrower’s gross monthly income. For example, FDIC’s IndyMac Federal Bank loan modification program, on which HAMP is partially based, initially reduced payments to 38 percent of the borrower’s gross monthly income before subsequently revising the payment target to 31 percent. Many servicers continue to offer non-HAMP loan modifications for borrowers who do not qualify for HAMP. Appendix I provides examples of non-HAMP loan modification programs and an overview of other federal foreclosure prevention programs. Treasury first announced HAMP in February 2009 and issued the first implementation guidelines in March 2009. Since then, Treasury has issued 11 supplemental directives for the HAMP program, 8 of them for the first- lien modification program (fig. 2). The early supplemental directives tended to focus on basic implementation issues, but the later directives resulted in significant changes to the program—for example, requiring servicers to send written denial notices to borrowers, streamlining the process used by servicers for evaluating borrowers, and requiring that servicers verify borrowers’ income before initiating trial modifications. As of March 9, 2010, 113 servicers had signed HAMP Servicer Participation Agreements to modify loans not owned or guaranteed by the government sponsored enterprises (GSE) Fannie Mae and Freddie Mac. Roughly $36.9 billion in TARP funds have been allocated to these servicers for modification of non-GSE loans. These servicers include national financial institutions such as Bank of America, Wells Fargo, and JP Morgan Chase and national servicing organizations such as GMAC Mortgage and Ocwen. Fannie Mae and Freddie Mac required all servicers of loans that they owned or guaranteed to participate in the GSE HAMP program. Treasury reported that through February 2010 servicers had offered nearly 1.4 million HAMP trial modifications to borrowers of GSE and non-GSE loans, and roughly 1.1 million of these had begun HAMP trial modifications. Of the trial modifications begun, about 0.8 million were in active trial modifications, fewer than 0.2 million were in active permanent modifications, and the remaining had been canceled. As shown in figure 3, the number of trial modifications started generally increased until October 2009 but then decreased. In part, the decrease in new trial modifications may be the result of a shift in focus on the part of Treasury and the servicers from starting new modifications to making existing trial modifications permanent. In July 2009, Treasury announced a goal of 500,000 trial modifications started by November 1, 2009. In November, however, Treasury announced a campaign to increase the number of conversions to permanent modifications. Although the first trial modifications started nearly a year ago, servicers are completing permanent modifications at a rate slower than Treasury expected, with 32 percent of loans that have been in trial for 3 months or more approved for conversion. Servicers we spoke with cited several challenges in making trial modifications permanent, including obtaining all the required documentation and borrowers who missed trial period payments. To date, Treasury has reported limited information on the number of borrowers who have been denied trial modifications under HAMP. The 10 HAMP servicers that we spoke with reported a wide range of denial rates. The reasons for denying trial modifications varied by servicer—for example, one servicer reported high proportions of investors prohibiting HAMP modifications and another servicer reported insufficient or excessive borrower income as the most common reasons for denial. Additionally, Treasury has provided limited data on the performance of HAMP modifications, both trial and permanent.