Could mortgage reserve accounts reduce minority foreclosures?

Reducing the size of a down payment and instead using the funds to create a mortgage reserve account could lead to fewer foreclosures and stability in Black homeownership rates, a newly released study said.

The report is the third in a series of papers from the Racial Accelerator for Homeownership, a partnership between the Federal Home Loan Bank of San Francisco, which sponsored the research, and the Urban Institute, the primary authors.

While the FHLBank-San Francisco hasn't examined how to implement the recommendations, "what it does tell us is that this could be a really great solution for helping people stay or maintain their homeownership," said Teresa Bryce Bazemore, president and CEO.

Driving the recommendation is the finding that annual foreclosure rates for Black homeowners between 2015 and 2018 were 2.09%, compared with 0.94% for whites, UI researchers estimated using American Community Survey and CoreLogic data.

"One of the main takeaways of this paper was the power of loss mitigation tools for racial equity" in sustainable homeownership, said Katie Visalli, a research assistant in the UI's Housing Finance Policy Center, and one of the authors of the report. "Homeowners of color are more likely to be foreclosed on, and also more likely to suffer the shocks that lead to foreclosure and default."

Most foreclosures are caused by the borrower experiencing an income or expense shock, such as job loss or unexpected costs such as medical. The homeowner has little in terms of financial reserves in order to cover their mortgage.

The primary solution the report suggests is to create reserve accounts, which are described as "sidecar savings accounts on the mortgage."

The Federal Home Loan Bank system could facilitate a pilot program for mortgage reserve accounts, the paper states.

"This isn't the only answer," said Laurie Goodman, co-author and founder of the Housing Finance Policy Center. "This is just one thing that we think actually has a lot of potential."

Forbearance is another effective tool, Goodman noted. But a reserve account that can be drawn upon would have the benefit of keeping the borrower current, where for technical purposes, a borrower in forbearance is recorded (although not treated) as delinquent and the missed payments might have to be made up.

Such measures have been attempted previously, including in a 2017 pilot from Prosperity Now, but a 2020 report noted that it was resource-intensive for the organization to administer.

More recently, the Self Help credit union network rolled out the Savings Account for Emergencies program, where it contributes an initial $2,000 to this account if the homeowner agrees to make a $25 automatic deposit each month. This program is still in its early stages.

Both Fannie Mae and Freddie Mac are looking at reserve account programs as part of their equitable housing finance plans, the report noted.

Reserve accounts where part of the down payment is shifted to fund it does reduce overall losses, but the loss severity for the lender could be higher.

The best available data shows that the trade-off is "economically worth it," said Janneke Ratcliffe, the UI's vice president for housing finance policy and another co-author. "[If] we could have some pilots of this, it would really help advance the case so that we can figure out how to do it at scale."

And Bazemore, who had served as president of Radian Guaranty before taking on her current position, noted that in the immediate aftermath of the Great Financial Crisis, borrowers need to put a minimum of 5% down.

Eventually, that was moved to 3% as studies showed little risk of additional loss.

"If you're able to help someone get through a short term payment issue, so that they don't fall, it's a win all the way around if you're able to keep people out of being in default," Bazemore said. That is not just the borrower, but the loan investor, the servicer and even the mortgage insurer.

Right now, the UI is looking at a potential pilot as primarily a bank portfolio product, Goodman said. Several FHLBanks offer their members secondary market alternatives to Fannie Mae and Freddie Mac, through the Mortgage Partnership Finance program; the Mortgage Partnership Program; and the Mortgage Asset Program, which could serve as outlets.

However, FHLBank membership is not open to independent mortgage bankers, so they could not directly participate in any potential pilot.

The report does look at some form of insurance as one alternative for foreclosure prevention in these circumstances, but it notes the limitations.

"Although the pooled risk approach is more efficient than having each borrower carry their own dedicated reserve account, an insurance-based approach would involve an additional sector of the financial services industry (insurance), which brings a thicket of regulatory and structural challenges," the report said.

For example, mortgage protection insurance, which the report defines as an optional policy the borrower purchases that covers payments for such events as death, disability or unemployment. (This is different from private mortgage insurance, which is required as lender risk mitigation when the borrower puts less than 20% down on a conforming mortgage.)

Those policies are less flexible and more costly than other forms of life, disability and unemployment insurance, the report said.

Another option discussed – and partially dismissed — is PMI where the borrower is the beneficiary, instead of the lender.

For example, the Massachusetts Housing Finance Agency offers the MIPlus Mortgage Payment Protection program at no additional cost on all conventional loans it insures,

The borrower's payments are covered up to $2,000 per month for six months. MassHousing, which services the loans in-house, says the program keeps the borrower current and thus avoids a lender PMI claim if the loan forecloses.

MIPlus has been paid to about 1,400 borrowers with only 196 loans going through the traditional PMI claims process.

"Although MIPlus benefits the borrower and MassHousing has seen positive financial outcomes, major structural challenges would need to be overcome to reach nationwide scale," the report said. "One challenge is that insurance laws and regulations vary by state."

PMI companies could offer this type of coverage, but also face costs, risks and process frictions. Given that their business is conventional loans, it would not make economic sense to offer it for government-guaranteed mortgages that many minority borrowers rely on.

Compared to those alternatives, mortgage reserve accounts are flexible and can be built into the loan itself, Goodman said.

But don't expect a pilot to start immediately, Bazemore and the researchers all agreed.

"This is really kind of a starting point that says, 'hey, based on the research and analysis we've done, this is worth spending some time to think about whether there's a way to put something like this in place,'" Bazemore said.