Government's Loan Modification Program Shows Promise

In previous columns, I have criticized the Obama administration's new Making Home Affordable foreclosure prevention program because it ignores negative equity -- the major factor underlying the horrendous foreclosure rate -- and because it offers refinance relief only to borrowers lucky enough to have their mortgages owned or guaranteed by Fannie Mae or Freddie Mac.

In this column, I will look more closely at the loan modification part of the program, which covers mortgages owned by any investor.

Like the refinance program, the loan modification part of the administration program ignores negative equity and offers help only to owner-occupants. Investors are not eligible. Those negatives aside, the modification program is well designed. Its architects have taken note of a number of problems that have bedeviled existing modification programs and have fashioned sensible remedies to deal with them. Among those problems:

-- Shortages of trained staff. Loan servicers are facing a shortage of qualified workers. That, as well as the high cost of modifying loans, has resulted in many needless foreclosures that timely modifications could have prevented. The government remedy is to provide financial incentives to servicers, enabling more modifications.

Under the administration program, servicers are paid $1,000 for each eligible loan they modify, provided that the modified loan remains current at least 90 days. In addition, the servicer collects $1,000 a year for three years if the borrower stays current for that period.

-- High incidence of re-default. In the past, many borrowers with modified loans have defaulted again. Many of those early modifications did not reduce the borrower's payment, and in some cases the payment increased.

Under Making Home Affordable, the interest rate is reduced to a level where payments for principal, interest, taxes and insurance amount to no more than 31 percent of the borrower's gross income. In addition, a borrower who stays current will receive $1,000 a year for up to five years in the form of balance reductions.

-- Restriction to borrowers in default. For the most part, servicers have limited modifications for borrowers who are two or more payments behind. This rule assured compliance with investor requirements that modifications were allowed only to avoid more costly foreclosures, and it also helped servicers allocate their limited staff to the most urgent situations. But it had the unfortunate effect of encouraging borrowers to default so that they could get help.

The new program attempts to remedy this by establishing a "hardship" criteria for eligibility that does not require the borrower to be in default to qualify for a modification. In addition, bonuses of $1,500 to the investor and $500 to the servicer are offered for each modification that is executed while the borrower facing hardship is still in good standing.