Thanks, but no thanks

Mortgage servicers aren't modifying the loan terms of troubled borrowers fast enough to prevent another wave of foreclosures this year and next -- but they may not be entirely to blame.

Prices are falling so fast in some markets that buyers may not see offers like an interest rate freeze on an ARM loan as enough of an incentive to prevent them from walking away from a home that's become worth less than they owe.

That's one possible conclusion to be drawn from a survey of bank loan officers released today by the Federal Reserve.

Introductory rates on an estimated 1.3 million subprime ARM loans are scheduled to reset this year, with another 422,000 resets to follow in 2009. Those are just the numbers for owner-occupied homes, not those purchased by speculators.

The trend is one reason FDIC chairwoman told Senate lawmakers last week that as bad as things got last year -- there were 1.1 million foreclosures in the first three quarters of 2007, a 60 percent increase from the previous year -- they could easily get worse.

Bair has been pushing for loan servicers -- the folks who collect monthly payments from homeowners, often on behalf of Wall Street investors who own complex securities backed by the loans -- to start modifying ARM loans in large batches, rather than on a case-by-case basis, before the introductory rates reset.

The "net present value" of a large pool of ARM loans is likely to be less if you foreclose on properites instead of trying to keep borrowers current on their payments by freezing interest rates or making other loan modifications, Bair testified.

That view has pretty much become the official policy of loan servicers who have joined the Bush administration's voluntary HOPE NOW alliance. Those servicers have agreed to use a set of standard guidelines developed by the American Securitization Forum to conduct wholesale loan modifications.

Despite agreeing in principle to wholesale loan mods, "progress in achieving actual loan modifications has been unacceptably slow and the increasing levels of foreclosure remain too high," Bair warned Senate lawmakers.

Until now, the conventional wisdom has been that loan servicers were unwilling or unable to conduct wholesale loan modifications. Some have pointed to pooling and servicing agreements (PSAs) governing loans that are bundled up and sold to investors as a potential obstacle. Others say loan servicers just don't have enough manpower to do workouts and loan mods fast enough.   

A survey of bank loan officers released today by the Federal Reserve suggests another reason.

Nearly nine out of ten loan officers surveyed by the Fed said that loan-by-loan modifications based on each borrower's unique circumstances will be a significant part of their loss mitigation strategies. Only about 45 percent said they expected that not having enough qualified loss mitigation specialists would pose a significant obstacle to implementing that and other loss mitigation strategies short of foreclosure, including refinancings and short sales.

Only one in three loan officers expected to employ the kind of streamlined modifications proposed by Bair and agreed to by members of the HOPE NOW alliance, even though most did not expect legal restrictions like PSAs would be a significant problem.

Bank loan officers tended to see borrowers as their biggest obstacle to implementing loss mitigation strategies short of foreclosure. More than 61 percent expected contacting borrowers would be a signficant problem. The biggest potential problem -- with three in four loan officers anticipating it will prove to be a significant obstacle -- is that borrowers "are less motivated to retain posession of property."

That's an opinion, and of course lenders will tend to see borrowers, not themselves, as the problem. But the idea has a ring of truth to it. For a borrower whose house is worth less than they owe, is an interest rate freeze really much of a deal? As Bair noted in her testimony to the Senate Banking Committee, even the introductory rate on many ARM loans can be higher than that for prime, fixed-rate loans.

Loan servicers may be better off foreclosing in some instances -- especially on loans made to speculators, or when fraud was involved. But in others, they might have to do more than freeze interest rates. They might have to write down part of the principal, Bair said.

If the problem of upside down home owners is a problem on many ARM loans, it's going to be an even bigger issue with the 1.7 million nontraditional interest-only and payment-option loans the FDIC says were out there as of last October. That's another $600 billion in loans securitized in alt-A pools, and Bair warned that something like 75 percent of those borrowers were probably making the minimum payments -- meaning their loans were negatively amortizing, and they could be upside down even if prices aren't falling in their market.

When first proposed, interest rate freezes were derided by some critics as a free ride for irresponsible borrowers. That many troubled homeowners may now see such offers as little more than an opportunity to dig themselves into a deeper hole is another worrisome sign that there's no stopping the wave of foreclosures building now.

Bair said subprime hybrid ARM resest are expected to peak at more than 350,000 loans in the third quarter of the year -- July, August and September. That compares to about 270,000 resets in January, February and March of this year.

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