Net Present Value and Loan Modifications

We recently posted a blog article that talked about why loan modifications weren’t working. In that article, we talked about the financial incentives the lenders and servicers have to foreclose.

However, there’s another reason that few people are talking about. It’s a mathematical calculation called Net Present Value (NPV). That calculation looks like this:

Easy to understand, right? I didn’t think so either. However, I think this might be the missing piece of the puzzle for a lot of borrowers looking to save their home.

I love strategy, so I see this as an opportunity to understand what the lender is looking at when a borrower submits a loan modification package. You, the borrower, can use the same calculations to make your loan modification application more attractive to a lender and presumably obtain a better outcome.

NPV is the total present value of a time series of cash flows. It’s a formula used to take cash flow expected in the future and discount it back to its present value. Each present value is then added together and the sum, minus any outflow, is the net present value of the cash flow at the rate used to discount it back.

Essentially, NPV compares the value of a dollar today versus the value of that same dollar in the future.

Servicers began using the NPV calculation in June 2007, when the American Securitization Forum , a special interest group for “participants” in the U.S. securitization market, provided guidance on evaluating loan modifications. That guidance directed loan servicers to compare the anticipated recovery under the loan modification with the anticipated recovery through the foreclosure process using the net present value calculation.

California SB 1137, signed into law by Governor Schwarzenegger on July 8, 2008 added a new provision to the California Civil Code to provide that: “Under specified circumstances, mortgage lenders and servicers are authorized under their pooling and servicing agreements to modify mortgage loans when the modification is in the best interest of lenders.” Congress also passed the Hope for Homeowners Act of 2008, which added a new section to the Truth In Lending Act, which contains similar language.

Notice that the legislation says that servicers are allowed to act in the best interest of the investors, not the homeowner. Essentially, whichever option, a loan modification or foreclosure, provided the best recovery for the investor would be pursued by the servicer.

Servicers look at the following when calculating NPV:

1. The proceeds expected from liquidation and sale of the mortgaged property through foreclosure, taking into account the current market value as indicated by a broker’s price opinion, automated valuation methodology or appraisal;

2. The costs to foreclose, repair and maintain the property;

3. The time to dispose of the property if not sold to a third party bidder at the foreclosure sale;

4. The costs incurred to market and sell the property as bank owned; and

5. The net sales proceeds. The discount rate to be used to calculate the net present value might be the net mortgage rate due to the investors.

The resulting number is the “Liquidation Proceeds NPV.”

Next, the servicers compare that number to NPV of the cash flows expected from a loan modification that is successfully paid.

Then, everything else being equal, the servicer should choose which option results in the higher NPV. Sometimes, that calculation will show that it’s better to foreclose on the property, and other times it will show that it’s better to modify the loan.

Check out this chart from the Mortgage Bankers Association that shows a complete calculation to compare the Liquidation Proceeds NPV and the NPV of a loan modification.

Conceivably, a homeowner could calculate both NPV’s and figure out whether the lender would approve their loan modification in advance, which could also save them some time and money.

Josh and I are working on a NPV calculator….stay tuned.