Why Modifying Mortgages Is Harder Than It Seems
THOUGH THE foreclosure crisis is serious, there has at least been widespread agreement on the optimum solution: Get more lenders to modify the loans of more homeowners. Whittling down the principal, interest or both should benefit all concerned: Borrowers get to keep their houses; lenders save the huge cost of repossessing and reselling a distressed property; and neighborhoods avoid the contagion of declining real estate values. It should be a win-win-win -- which is why the Bush administration launched an effort to encourage loan modifications, and the Obama administration greatly expanded it.
Yet none of these programs has quite lived up to its promise. Under the Obama administration's Home Affordable Modification Program (HAMP), the Treasury Department offered lenders up to $75 billion to help them defray the cost of reducing borrowers' monthly payments to 31 percent of their incomes. It also enticed loan servicers with $1,000 for each modification, plus another $1,000 for each modified loan that is still performing after three years. The administration estimated that as many as 4 million households might benefit. But after four months, only 350,000 borrowers have even been offered new loans, just over half of which have gone into effect, according to the Treasury. Meanwhile, 1,155,299 properties faced new foreclosure filings from March through June, according to RealtyTrac.
It's still too early to pass final judgment on HAMP. Cleary the program and others like it are struggling in part because of the rising rate of unemployment, which makes it impossible for many people to pay any kind of mortgage, even a more affordable one. No doubt, as critics of the financial industry suggest, many servicers have been slow to train enough staff to do modifications and investors in mortgage-backed securities pose a lingering obstacle.
But new research suggests that the loan-modification effort may also be based on faulty economic assumptions. According to economists at the Federal Reserve Bank of Boston, the win-win-win concept of modification understates two of lenders' strongest incentives to foreclose. The first is that roughly 30 percent of troubled debtors eventually can pay without a modification; thus, for lenders, 30 percent of the total cost of modifying loans is wasted. And since lenders can't know in advance which 30 percent will "self-cure," they hesitate to offer any modifications.
The second problem is the risk that borrowers redefault on a modified loan. By the time that happens, the value of the house has declined further, and foreclosure costs the lender even more than it would have earlier. The HAMP program includes $10 billion for partial protection against that risk, but it may not be enough, especially given the sour outlook for employment.
In short, say the Boston Fed economists, "the number of 'preventable foreclosures' may be far fewer than many believe." That will not be a welcome finding in the administration or in Congress -- where impatience with the pace of loan modifications is growing. But it is a message that policymakers cannot afford to ignore.