National default and foreclosure rates rose sharply from calendar year 2005 through 2009 to the highest level in at least 29 years (fig. 1). Default rates declined slightly from the fourth quarter of 2009 to the first quarter of 2010 but, at 4.91 percent, were still more than six times higher than they were at the start of 2005. Foreclosure start rates—the percentage of loans that entered the foreclosure process each quarter—grew nearly three-fold in the 5-year period from 0.42 percent to 1.23 percent in the first quarter of 2010. Put another way, more than half a million mortgages entered the foreclosure process in the first quarter of 2010, compared with about 165,000 in the first quarter of 2005. Finally, foreclosure inventory—the number of houses for which the lender has initiated foreclosure proceedings but has not yet sold the properties—rose more than 325 percent from the first quarter of 2005 to the first quarter of 2010, increasing from 1.08 percent to 4.63 percent, with most of that growth occurring after the second quarter of 2007. As a result, as of the end of the first quarter of 2010, more than 2 million loans were in the foreclosure inventory. As we reported in December 2008, Treasury has established an Office of Homeownership Preservation within OFS to address the issues of preserving homeownership and protecting home values. On February 18, 2009, Treasury announced the broad outline of a three-pronged effort to help homeowners avoid foreclosure and provided additional program descriptions on March 4, 2009; April 28, 2009; and May 14, 2009: The Home Affordable Refinance Program (HARP), which provides a refinancing vehicle for homeowners who are current on their mortgage payments with mortgages held or guaranteed by Fannie Mae and Freddie Mac, interest rates higher than the prevailing market rates, and loan-to- value ratios of between 80 and 105. Using the prevailing interest rates in February 2009, Treasury estimated that between four and five million borrowers could refinance their mortgages through this program. No TARP funds will be used to refinance these loans. Instead, Fannie Mae or Freddie Mac, as the owner or guarantor of the loan, purchased or guaranteed the refinanced mortgages. The program has resulted in relatively few refinances—between February 2009 and March 2010, fewer than 292,000 borrowers were refinanced through this program. In March 2010, the program’s end date was extended from June 10, 2010, to June 30, 2011. An increased funding commitment from Treasury for preferred stock purchases from Fannie Mae and Freddie Mac to strengthen confidence in the two government-sponsored enterprises (GSE) and help support low mortgage rates. The preferred stock purchase agreements, authorized by the Housing and Economic Recovery Act of 2008 (HERA), were amended in May 2009 to increase Treasury’s commitment to each GSE from $100 billion to $200 billion. On December 24, 2009, the preferred stock purchase agreements were again amended with the provision that the $200 billion cap increase as necessary. The increased funding commitment would be made under HERA and would not require the use of TARP funds. Through March 2010, the cumulative reduction in the net worth of the two GSEs required them to draw $111 billion from the Treasury under the senior preferred stock purchase agreements. In May 2010, the Federal Housing Finance Agency requested an additional $10.6 billion in Treasury assistance for Freddie Mac and an additional $8.4 billion for Fannie Mae. HAMP, which was designed to commit up to $75 billion of GSE and TARP funds to offer loan modifications to up to three to four million borrowers who were struggling to pay their mortgages. According to Treasury officials, HAMP would use up to $50 billion of TARP funds, primarily to encourage the modification of non-GSE mortgages that financial institutions owned and held in their portfolios (whole loans) and mortgages held in private label securitization trusts. Fannie Mae and Freddie Mac together are expected to provide up to an additional $25 billion to encourage servicers and borrowers to modify loans owned or guaranteed by the two GSEs. As outlined in the March 4, 2009, program guidelines, HAMP’s eligibility requirements for first-lien modifications stipulate that: the property must be owner-occupied and the borrower’s primary residence (the program excludes vacant and investor-owned properties); the property must be a single-family property (one to four units) with a maximum unpaid principal balance on the unmodified first-lien mortgage that is equal to or less than $729,750 (for a one-unit property); the loan must have been originated on or before January 1, 2009; the borrower must complete a HAMP Hardship Affidavit documenting a financial hardship; and the first-lien mortgage payment must be more than 31 percent of the homeowner’s gross monthly income. The HAMP first-lien modification program has four main features: 1. Cost sharing. Mortgage holders and 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. For non-GSE loans, 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, investors no longer receive payments for cost sharing, and the borrowers’ interest rate 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 was prepared, and the borrower’s payments would increase to accommodate the increase in interest rate. The interest rate and monthly payments are then fixed for the remainder of the loan. 2. Standardized net present value (NPV) model. The NPV model compares expected cash flows from a modified loan to the same loan with no modification, based on certain assumptions. If the expected investor 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 model increases mortgage investors’ confidence that modifications under HAMP are in their best financial interests 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 as close to 31 percent of gross monthly income as possible. Servicers must first capitalize accrued interest and certain expenses paid to third parties and add this amount to the loan balance (principal) amount. Next, interest rates must be reduced in increments of one-eighth percent until the 31 percent debt-to-income target is reached, but servicers may not reduce interest rates below 2 percent. If the interest rate reduction does not result in a debt-to-income ratio of 31 percent, servicers must then extend the maturity and/or amortization period of the loan in 1-month increments up to 40 years. Finally, if the debt-to-income ratio is still over 31 percent, the servicer must forbear, or 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, provided that principal reduction is allowed by the investor. 4. Incentive payment structure. Treasury will use HAMP funds to provide both one-time and ongoing (“pay-for-success”) incentives for up to 5 years to non-GSE loan servicers, mortgage 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. Borrowers must also demonstrate their ability to pay the modified amount by successfully completing a trial period of at least 90 days before the loan is permanently modified and any government payments are made under HAMP. Treasury has entered into agreements with Fannie Mae and Freddie Mac to act as its financial agents for HAMP. Fannie Mae, as the HAMP program administrator, is responsible for developing and administering program operations including registering servicers and executing participation agreements with and collecting data from them. A separate division within Freddie Mac, the Making Home Affordable- Compliance (MHA-C) team is the HAMP compliance agent, and is responsible for assessing servicer compliance with non-GSE program guidelines, including conducting onsite and remote servicer reviews and audits. As of mid-June 2010, 109 active servicers had signed HAMP Servicer Participation Agreements to modify first-lien mortgages not owned or guaranteed by Fannie Mae and Freddie Mac. Roughly $39.9 billion in TARP funds has been committed to these servicers for modification of non-GSE loans. Based on the HAMP Servicer Performance Report through May 2010, more than 1.5 million HAMP trial modifications had been offered to borrowers of GSE and non-GSE loans, and more than 1.2 million of these had begun HAMP trial modifications. Of the trial modifications begun, approximately 468,000 were in active trial modifications, roughly 340,000 were in active permanent modifications, roughly 430,000 trial modifications had been canceled, and roughly 6,400 permanent modifications had been canceled. As of May 17, 2010, more than $132 million in TARP funds had been disbursed to HAMP servicers. Borrowers who received permanent first-lien HAMP modifications had high levels of total debt and high loan-to-value ratios.