Although default rates (loans 90 days or more past due) fell from an all- time high of 5.09 percent at the end of the fourth quarter of 2009 to 3.94 percent at the end of the fourth quarter of 2010 (a nearly 23 percent drop over the course of a year), the percentage of loans in foreclosure rose to equal the highest level in recent history at 4.63 percent (fig.1). The increase in foreclosure inventory during the latter part of 2010 may be due to issues surrounding foreclosure processing and procedures that resulted in various foreclosure moratorium initiatives. In addition, the percentage of loans that newly entered the foreclosure process in the fourth quarter of 2010 remained high at 1.27 percent, compared to 0.42 percent in the first quarter of 2005. As we reported in December 2008, Treasury has established an Office of Homeownership Preservation within the Office of Financial Stability (OFS), which administers TARP, to address the issues of preserving homeownership and protecting home values. On February 18, 2009, Treasury announced the broad outline of the MHA program. The largest component of MHA was the HAMP first-lien modification program, which was intended to help eligible homeowners stay in their homes and avoid potential foreclosure. Treasury intended that up to $75 billion would be committed to MHA ($50 billion under TARP and $25 billion from Fannie Mae and Freddie Mac) to prevent avoidable foreclosures for up to 3 to 4 million borrowers who were struggling to pay their mortgages. According to Treasury officials, up to $50 billion in TARP funds were to be used to encourage the modification of 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 were expected to provide up to an additional $25 billion from their own balance sheets to encourage servicers and borrowers to modify or refinance loans that those two Government Sponsored Enterprises (GSE) guaranteed. Only financial institutions that voluntarily signed a Commitment to Purchase Financial Instrument and Servicer Participation Agreement (SPA) with respect to their non-GSE loans are eligible to receive TARP financial incentives under the MHA program. HAMP first-lien modifications are available to qualified borrowers who occupied their properties as their primary residence, who had taken out their loans on or before January 1, 2009, and whose first-lien mortgage payment was more than 31 percent of their gross monthly income (calculated using the front-end debt-to-income ratio (DTI)). Only single- family properties (one-four units) with mortgages no greater than $729,750 for a one-unit property were eligible. The HAMP first-lien modification program has four main features: 1. Cost sharing. Mortgage holders/investors are 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 then uses 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 borrower’s interest rate may increase by 1 percent a year to a cap that equals the Freddie Mac rate for 30-year fixed rate loans as of the date that the modification agreement was prepared. The borrower’s payment would increase to accommodate the increase in the interest rate, but the interest rate and monthly payments would then be 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, using 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 an externally derived objective standard for all loan servicers to follow. 3. Standardized waterfall. Servicers must follow a sequential modification process to reduce payments to 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, the interest rate must be reduced in increments of one-eighth of 1 percent until the 31 percent DTI target is reached, but servicers may not reduce interest rates below 2 percent. If the interest rate reduction does not result in a DTI 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 target DTI ratio is still not reached, 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 the investor allows principal reduction. 4. Incentive payment structure. Treasury uses TARP funds to provide both one-time and ongoing incentives (“pay-for-success”) for up to 5 years to non-GSE loan servicers, mortgage investors, and borrowers. These incentives are designed to increase the likelihood that the program will produce successful modifications over the long term and help cover the servicers’ and investors’ costs for making the modifications. Borrowers must also demonstrate their ability to pay the modified amount by successfully completing a trial period of at least 90 days before a 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 MHA. With respect to Freddie Mac, these responsibilities are carried out by a separate division of that entity. Fannie Mae serves as the MHA program administrator and is responsible for developing and administering program operations including registering servicers and executing participation agreements with and collecting data from them, as well as providing ongoing servicer training and support. Within Freddie Mac, the MHA-Compliance (MHA-C) team is the MHA compliance agent and is responsible for assessing servicers’ compliance with non-GSE program guidelines, including conducting on-site and remote servicer loan file reviews and audits. Initially, only servicers who signed a SPA prior to December 31, 2009, were eligible to participate in MHA. Subsequently, the Secretary of the Treasury exercised the authority granted under the Emergency Economic Stabilization Act of 2008 to extend TARP’s obligation authority to October 3, 2010, which allowed servicers to continue to sign SPAs to participate in MHA until that time. As of December 31, 2010, there were a total of 143 active servicers. Through January 2011, $29.9 billion in TARP funds had been committed to these servicers for modification of non-GSE loans. Based on the MHA Servicer Performance Report through January 2011, nearly 1.8 million HAMP trial modifications had been offered to borrowers of GSE and non-GSE loans as of the end of January 2011, and nearly 1.5 million of these had begun HAMP trial modifications. Of the trial modifications begun, approximately 145,000 were in active trial modifications, roughly 539,000 were in active permanent modifications, roughly 740,000 trial modifications had been canceled, and roughly 68,000 permanent modifications had been canceled. Recently, the number of new trial and permanent modifications started each month has declined (fig. 2). As of December 31, 2010, $1 billion in TARP funds had been disbursed for TARP-funded housing programs, of which $840 million was disbursed for HAMP-related activity. Treasury has recently implemented programs to reduce or eliminate payments on second-lien mortgages, provide incentives for the use of short sales or deeds-in-lieu as alternatives to foreclosure, and provide incentives for the forgiveness of principal for borrowers whose homes are worth significantly less than their mortgage balances. However, as of December 2010, reported activity under these three programs had been limited. 2MP was announced in March 2009, and had disbursed $2.9 million out of nearly $133 million allocated to the program by the end of December 2010. In part, the limited activity appears to be the result of problems that servicers have experienced using the database that Treasury required to identify second-lien mortgages eligible for modification. Treasury has taken some steps to address these challenges, but could take further action to ensure that borrowers are aware of their potential eligibility for the program. HAFA was announced in March 2009 and had disbursed $9.5 million out of $4.1 billion allocated to the program by the end of December 2010. Restrictive program requirements—for example, that borrowers be evaluated for a HAMP first-lien modification before being evaluated for HAFA, appear to have limited program activity to date. Treasury has taken steps to revise program guidelines, but it remains to be seen the extent to which these actions will result in increased program activity. PRA was announced in March 2010 and Treasury had not reported activity as of December 2010 for this $2 billion program. Mortgage investors and others have cited concerns that the voluntary nature of the program and transparency issues, including concerns about the extent of reporting on PRA activity, may limit the extent to which servicers implement PRA.