Want to get a loan modification on your mortgage? First, you have to pass the NPV test.

The test is filled with secrets and uncertainties, but the grading is simple: You either pass or fail. Pass, and you are offered a mortgage modification. Fail, and you don’t get a loan modification.

NPV, which stands for net present value, is a concept used in making financial choices. “It’s a way for financial people to express a decision in today’s dollars,” says Brent Lippman, CEO of Response Analytics, a financial modeling company.

Mortgage servicers use an NPV test to decide which action is more profitable (or less unprofitable) in the long run:

  • Modifying the loan and accepting lower monthly payments.
  • Not modifying the mortgage and possibly tipping the borrower into foreclosure.

For the homeowner, the decision seems like a no-brainer: Modify the mortgage so it’s affordable and the loan won’t go into foreclosure. But a lot of modified mortgages wind up in default again, despite the borrowers’ intentions. So the net present value formula includes an estimate for the likelihood that the mortgage will redefault — that is, that it will end up in foreclosure, anyway, even after a modification.

What can homeowners do?
The NPV formula contains secret ingredients, so it’s hard for delinquent borrowers to influence the results when seeking a loan modification. But there are a couple of things you can do.
  • If you are determined to remain in the home, say so. Make it loud and clear that you don’t want to lose your home, and explain why. Maybe you live near your aging parents, who need your care-giving, or you would be intensely embarrassed by foreclosure. Enlist the aid of a nonprofit housing counseling agency to craft a hardship letter.
  • The federal government’s home value projections are updated at the beginning of each quarter. There’s a slim chance that the numbers could change in your favor from one quarter to the next, so if you are turned down for a mortgage modification, you might try applying again the following quarter (if it’s not too late).

Besides the redefault rate, the NPV calculation makes guesses about several things:

  • How many months are likely to pass, on average, before a redefault.
  • How likely the borrower is to catch up on the payments if the loan isn’t modified (the “self-cure rate”).
  • How much the home is worth now.
  • How much the home will be worth a year from now.
  • How much it would cost — from legal fees to utilities — to foreclose and take possession of the house.
  • How much the house would fetch in a foreclosure sale, using a formula that the government calls the REO discount.

For two of those items — the home’s projected value in a year and the REO discount — the servicer must use formulas crafted by the federal agency that oversees Fannie Mae and Freddie Mac. The servicer assigns its own values and probabilities to the other items. (REO stands for real estate owned, which is how a property is identified after it goes back to a mortgage company.)

These numbers are secret. They’re unavailable to borrowers. If you want to know your home’s estimated value a year from now, or the odds that you’ll redefault, no one will tell you.

The NPV test is a “black box” in which data goes in, a decision comes out, and borrowers aren’t privy to details about how the decision was made. The Federal Housing Finance Agency maintains secrecy over its formulas, updated at the beginning of each quarter, for calculating projected home values and REO discounts. Mortgage servicers don’t disclose the probabilities that they assign for redefault and self-cure rates and the rest.

Go public with calculations

Consumer advocates have lobbied, in vain, for this information to be made public. “Without access to the NPV analysis, homeowners are entirely reliant on the servicer’s good faith,” Julia Gordon, senior policy counsel for the Center for Responsible Lending, told the House Financial Services Committee Dec. 8.

Gordon added that “servicers should be required to allow borrowers to review the property valuation used in the NPV calculation, as it is one of the inputs with the greatest effect on the results.”

But servicers and government agencies have rebuffed such requests. They say the NPV calculation is beyond the comprehension of many borrowers.

“There’s always some desire for a level of transparency with the consumer,” says Joanne Gaskin, director of mortgage scoring solutions for FICO. “I think it’s important to educate them as far as the key variables that impact the decision, but actually giving the net present value engine to the consumer is probably not the best approach. It is a fairly complex process and decision for most average homeowners to understand.”

Maybe more important, secrecy allows servicers to avoid appeals and objections from borrowers who disagree with the home values and default probabilities embedded in the NPV test.

The federal government has come up with two NPV models that, in their simplest format, can be deployed as spreadsheets. (The Treasury and FHFA developed the NPV model used in the Home Affordable Modification Program, or HAMP, and the FDIC built an NPV model dubbed “Mod in a Box.”) Some servicers customize these basic NPV models, transforming them into databases that pull information from many sources. Response Analytics and FICO belong to this modification customization industry.

Gaskin, of FICO, says almost half of servicers use spreadsheets to make modification decisions. Someone manually inputs information into the spreadsheet, which yields a decision. It’s a static, relatively primitive method.

The biggest servicers, Gaskin says, have more sophisticated NPV decision engines with “all sorts of data input at the ready,” including FICO score, total debt obligations, household income and the probability that the borrower will walk away from the loan. The walk-away probability is based on factors such as location and how much more the borrower owes than the house is currently worth. The data can be refined and updated frequently, based on results of the servicer’s past mortgage modification decisions.

FICO and Response Analytics develop borrower profiles. “What you do is define groups of different types of borrowers,” says Lippman, of Response Analytics, “so you can infer behavior from others like them.”

This analysis includes “psychographic factors,” including the depth of the desire to stay in the home. For example, Lippman says, if you tell the servicer that you have deep roots in your hometown, with lots of family and friends, and you don’t want to be embarrassed by foreclosure, you will be deemed less likely to redefault.

This likely marks the best opportunity to influence the mortgage servicer’s decision. Loan modification applications include a hardship letter, in which you explain why you need a lower monthly house payment. If you want to keep the house, it’s important to make this clear in the hardship letter. Explain why you want to keep the house: for example, to avoid the embarrassment of foreclosure, or because you grew up in the house and it has sentimental value.

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