OneCalifornia Bank Viewpoint 

OneCalifornia Bank, FSB, November 20, 2007  Download PDF

An Alternative Approach to Dealing with the Subprime Crisis:
“Everyone works on it!”

This approach involves working directly with borrowers who have subprime mortgages, holders of subprime mortgages, those who services subprime mortgages and investors in investments backed financial instruments backed by subprime mortgages. 

This approach does not require the establishment of massive federal or private funds to bail out families under stress or financial firms who originated and held the mortgages or investors who are holding paper backed by subprime mortgages. Nor does this approach require significant changes or intervention by government service entities such as Fannie Mae.

This approach requires the major players who created this market (subprime mortgage funders, servicers and investors) to restructure the underlying mortgages to keep the borrowers in their homes thus avoiding the downward spiraling impact of foreclosures on families, their neighborhoods, cities and government services. Some of the mortgage originators may also be captured in this net (such as bank originated subprime loans), but it is recognized that many of the originators were real estate brokers working for real estate brokerage and mortgage banking companies.

This approach does require modification to existing banking regulations to encourage banks to aggressively and actively work with borrowers.

The basic premise for this approach is based upon a two-prong approach:

A direct approach through financial institutions operating under Federal and State Banking Regulations and
An indirect approach involving mortgage services and holders of paper backed by subprime mortgages.

The basic premise is working with borrowers who have made payments on time under their original note terms, but who are now under financial stress due to re-pricing/rate adjustments in their adjustable rate loans. It is critical to recognize the past good payment history of this segment of borrowers and to try to establish repayment programs that allow a borrower to continue to be a productive member of their community. 

The personal financial and human cost of foreclosures is significant and we are now seeing the costs grow as foreclosures negatively impact the finances of cities, counties and states. Charging a loan off maybe an accounting solution driven by regulatory requirements, but it is not the longer term social / community / economic impact solution we should be seeking.

Direct Approach: Modify, Save & Educate:

Banking Regulators set strict performance guidelines for banks in terms of past due loan payments, restructuring of loans, capital allocation, funding and overall assessment of risk management. 

Bankers who work proactively and successfully with borrowers under distressed often come under increasing regulatory criticism for the impact that working with borrowers under distress causes to the overall financial health and risk rating of their banks, such as increasing past due loans, maturity extensions and even the creation of negative amortization loans. Additionally, shareholders of banks are distressed at the current state of affairs and wonder if the banks have truly recognized the full extent of the subprime mortgage carry.

Bankers need to be able to restructure subprime loans for those borrowers who have had a prior successful payment history before the interest rates on the mortgages have reset or for those borrowers who have had a good repayment past but are now under financial stress due to interest rate resets. Banks should be allowed to modify rate, terms and maturities as follows:

Banks:

a. Keeping borrower at current interest rate and only adjusting the rate upwards commensurate with changes in either the 10 yr or 30 Treasury rather than the note rates and rate adjustments contained in the original loan documentation.
b. Allow the difference between the modified interest rate and the original note rate to be added onto the principle balance in the manner of a negative amortization loan.
c. A cap on the amount of negative amortization needs to be set. A combination of negative amortization with an equity share between the bank and the borrower on long term appreciation of the home could be explored.
d. While the principle balance owed may grow due to the negative amortization and the monthly principle and interest payments grow modestly with changes in either the 10 yr or 30 yr treasury, the final maturity of the loan should remain as the original provided the original maturity was at least 10 years out. Therefore a 3-year adjustable rate mortgage would have an extension of the maturity to 10 years.  The ten year time period should give the housing market time to recover and reset.
e. Work with community organizations to provide annual financial literacy programs to borrowers.
f. Banks commit to not cross sell other credit products, which would cause the borrower to simply move debt from one product to another. Goal is financial stabilization leading to mortgage payoff.

Borrowers:

g. Borrower cannot refinance home in the future to obtain more funds other than to completely pay off the existing mortgage. This prevents the borrower from getting into more debt.
h. Borrower is required to go on direct deposit of payroll and use of direct debit for mortgage payments and escrow amounts for taxes and insurance.
i. Borrower is required to attend annual financial education classes.
j. Borrower is required to set up an emergency savings fund equal to 6 months of estimated mortgage and living expenses. This fund will cover emergency such as loss of employment. Banks will be required to assist borrowers in opening free savings accounts and to automatically transfer from checking to savings regardless of the amount the borrower can afford.

Banking Regulators:

a. Borrowing from the S & L crisis of the past, Banking Regulators should allow banks to create a good bank and the subprime bank.  The subprime bank is a vehicle to house the loans and attendant costs associated with servicing the loans. Bank financial and regulatory reporting would be along both lines. 
b. Regulatory requirements and standards should be adjusted/modified to recognize the efforts the banks are undertaking to try and keep families in their homes as productive citizenry of their communities. Examples would be in the following areas:
i. Levels of past due payments allowed.
ii. Required actions forcing banks to begin the notices of default and foreclosure processes are dramatically changed.
iii. Loan loss provisions and related ratios would increase.
iv. Level of risk-based capital assigned to restructured loans need to be changed based upon performing longer-term loans.
v. Readjustments on risk grading approaches on subprime loans recognizing the restructured loan.
vi. Funding strategies on how a bank would finance its level of restructured subprime loans.

c. The CDFI Fund under the Department of Treasury should be significantly expanded and used as an incentive tool to the best in practice banks that provide the direct modification/savings/education programs.

Indirect Approach: Modify, Save & Educate: Working with non bank lenders, non bank mortgage servicing companies & holders of subprime mortgages

Mortgage servicing firms and the investors need to play the same role as the banks from the above example in working with borrowers to provide the mortgage restructuring outlined above, along with the financial education and required savings. Much as banks need banking regulations adjusted/modified the mortgage servicing companies need contractual adjustments to allow them to become as proactive as the banks would be in restructuring the mortgages.

Lenders who provide liquidity to this sector would need to agree to the extended and extensive restructuring of the underlying mortgages. Banks who have provided such liquidity would need to move these lines into their subprime bank and again the Banking Regulators would need to make the appropriate adjustments in their regulatory requirements.

No doubt some may see this recommendation as re-directing the financial stress the families are under to the financial players. However, it is our belief that by all players shouldering parts of the effort, we can achieve a situation where the damaging effects of the subprime market are better managed on a multitude of levels with minor federal and state intervention and funding.