When a lender/servicer is requested to consider doing a loan modification, the lender/servicer is bound by the language of the Pooling and Servicing Agreement.  The Pooling and Servicing Agreement covers all aspects of the securitizatiion of the loan, as well as describing when and how a loan can be modified.  The general language of the Agreement gives authorization for the loan mod to the Master Servicer when the loan is in default or likely to default.  The loan mod can then take the form of being either a reduction in the interest rate and payment, and on very few occasions, a principal reduction. The Master Servicer may delegate this authority to a Sub-Servicer, but that is not often the case.

Under the guidelines of the Pooling and Servicing Agreement, if a lender/servicer is considering a loan modificatiion for a client, then the lender must perform a Net Present Value test.  The purpose of the test is to determine whether a loan modification or foreclosure will result in the greater profit to the investor.  Whichever results in the greater profit, that is the resolution to the problem. 

"A participating servicer in the Home Affordable Modification Program must modify any loan that meets the program’s eligibility criteria if the modification tests “positive” for NPV. When mortgage modifications have a positive NPV, it is in the best interests of lenders, servicers, investors, and borrowers to modify mortgages to reduce the risk of foreclosure. The Home Affordable Modification Program increases the potential number of mortgage modifications that will have a positive NPV, resulting in more servicers modifying mortgages, and keeping more Americans in their homes. The Home Affordable Modification Program specifies a precise method for determining NPV and provides a base NPV model that any servicer can use or customize into a proprietary NPV model that satisfies all of the program’s methodological requirements."

"Net Present Value of Modification
In general, NPV refers to the value today of a cash-generating investment – such as a bond or mortgage loan. When an investor is faced with a choice between two alternative investments – specifically, between the timing and amounts of the cash flows for each investment – the investor obviously prefers the choice that has a higher present value."

The Net Present Value Test has been, for most purposes, designed by the Federal Government and the Making Home Afffordable Program.  It uses a very specific set of guidelines to make the determination of whether to grant a loan modification or foreclose. 

Both the base NPV model and a servicer’s proprietary customized version will:

• Determine the probability that the mortgage defaults.

• Project the future cash flows of the mortgage if it defaults and the present value of these cash flows.

• Project the future expected cash flows of the mortgage if it does not default and the present value of these cash flows.
• Take the probability weighted average of the two present values.

 2.  In the same manner, compute the net present value of the mortgage assuming it is modified, incorporating the effects on cash flows and performance of the modification terms and subsidies provided by the Home Affordable Modification Program.

3.  Compare the two present values to determine if the HAMP modification is NPV positive.

• legal expenses,
• lost interest during the time required to complete the foreclosure action,
• property maintenance costs, and
• expenses involved in reselling the property.

• a lower monthly payment from the borrower,
• the likelihood a borrower will default even after the loan is modified,
• financial incentives provided by the government, and
• the likelihood that a loan will be paid off before its term expires (prepayment probability).

The following are parameters used in the  determination of the Net Present Value Test:

1.  Discount Rate - The Discount Rate is the rate that is factored into a series of payments to "make up" for receiving cash at a later date instead of right now. For the Net Present Value Calculation, the servicers  are required to use the Weekly Fannie Mae Rate for 30 year fixed rate loans.  The servicer does have the option of adding up to 250 basis points to the weekly rate, as  long as both Net Present Value streams are treated equally.

2.  Default Rate - The default rate is based upon projections of probability of default for if the loan was modified and if it was not modified.  Factors relating to the default rate are loan to value, debt ratios, credit history and where in the foreclosure cycle the homeowner is.  Large servicers with over $40 billion in loans can modify default rates to match their experience levels.

3.  Home Price - The value of the home based upon the model provided by the government.

4.  REO Discount - This is based upon "assumptions" of what the home value is expected to do from an historical perspective in relation to the foreclosure crisis.  It is a value set by the government.

LFI has been trying for months to determine the actual values being used by the servicers for the NPV model.  This is apparently a well kept secret that is held between the servicers, the investors, and the government agencies issuing the guidelines.  The details are being closely held in order that loan modification companies and attorneys cannot obtain this information and then be able to determine the appropriateness of the loan modification decision.