Jack Guttentag: The Mortgage Professor

By Jack Guttentag
Saturday, January 3, 2009

Q: Do borrowers have any say over the type of loan modification they get? What kind of modification should they look for?

A: Mortgage modifications are changes in the terms of a loan designed to make it more affordable. Generally, modifications are available only to borrowers in default or in imminent danger of default. The purpose is to avoid the default, thereby heading off foreclosure.

In general, borrowers must take the modification they are offered, as they have very little bargaining power. Their only card -- the implicit threat that if they don't receive an adequate modification, they will default -- is one they can't play, at least not explicitly. However, borrowers can indicate what they can afford to pay, without it being perceived as a threat.

Generally, a modification that helps a borrower hurts the investor who owns the loan. Here are the major types of modifications, in order of their value to the borrower and cost to the investor.

· Capitalization of arrears: The past-due payments and perhaps late fees and other charges arising out of delinquencies are added to the loan balance. A new payment is then calculated. It will be a little higher than the previous payment.

This is the most common type of modification because it has very little cost to the investor. Its only value to the borrower is that it provides a new start by making him current. It works for a borrower who has hit a temporary rough patch and is now back on track, but not for a borrower who needs a lower payment.

· Extension of the term: A term extension is the payment-reduction modification that is least costly to the investor. However, if a loan was originally 30 or 40 years and it is now only a few years old, the payment can't be reduced very much this way. If the loan was originally for 10 or 15 years, a term extension to 30 years will reduce the payment materially, but 10- and 15-year loans account for a very small share of loans in distress.

· Reduction in interest rate: This is a more effective way to get the payment down. Cutting the interest rate on a 30-year loan from 6 percent to 3 percent will reduce the payment by about 30 percent, whereas extending the term to 40 years reduces it by only 8 percent. Rate reductions are flexible, because they can be adjusted to the needs of each borrower.

They are more costly to the investor than a term extension. To minimize the cost, rate reductions in some cases are temporary. The modification may call for the original rate to be phased back over five years, for example. This presumes that the borrower's payment capacity will grow over that time.

· Freeze the interest rate: On adjustable-rate mortgages that are close to a rate reset date, where the new rate and payment will be well above the one the borrower is paying, a modification can freeze the rate and payment at the current level. Many subprime loans have been modified in this way because they carried margins of 5 to 7 percent, which when added to the current value of the rate index, would have resulted in substantial increases in rates and payments.

· Reduction in loan balance: The mortgage payment declines in tandem with the balance. A 20 percent drop in the balance, for example, results in a 20 percent drop in the payment. Unlike a cut in the interest rate, however, a cut in the balance can't be temporary, which makes it the most costly modification for investors and the best one for borrowers.

Balance reductions do have one major advantage for investors: They reduce the borrower's negative equity, which increases the borrower's incentive to do everything possible to keep the house. It is plausible that re-default rates on loans that are modified with a balance reduction are materially lower than on other types of modifications.

New data from the Office of the Comptroller of the Currency show that about half of all modified loans re-default within six months. I am told that breakdowns of re-default rates by type of modification soon will be available.

Modification decisions are made not by investors but by servicing agents under contract with investors. These agents generally view balance reductions as a last resort. It is not in their interest to cut balances because their servicing fees are based on the loan balance. A 20 percent cut in the balance also means a 20 percent cut in the fee.

Probably more important to their decision process, the initial cost of balance reductions is higher than that of rate reductions, which imposes a burden of proof on servicing agents to justify balance reductions to investors.

Their argument has to be that a balance reduction has a materially lower probability of re-default, but so far only sketchy facts have been available to support that. I hope this will change soon.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

© 2009 Jack Guttentag

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