John X had his home foreclosed this year. It cost the investor who held the mortgage about $40,000 to foreclose. It would have cost only $25,000 to make the mortgage affordable to the borrower through a reduction in the interest rate. Modifying the loan contract in this way would have kept X in his home and saved the investor money. This is not an isolated case; preventable foreclosures are happening all around us.
Note that I am using a cold-blooded business, not a bleeding-heart definition of "needless foreclosure." Under my definition, if it costs an investor more to foreclose a mortgage than to make it viable, it is a needless foreclosure. I am not counting the additional human toll exacted by foreclosures, which can be very high.
Mortgage contracts are modified, at some cost to the investor, in order to prevent the larger cost of a foreclosure later on. Loan modifications include adding the unpaid interest to the loan balance, called "interest capitalization," and calculating a new payment. To make the payment more affordable, the term may be lengthened or the interest rate reduced. In cases where the property is worth less than the loan balance, the balance may be reduced.
The problem is that there are major impediments to loan modifications, including:
- Borrower denial. Developing a new loan contract that a distressed borrower can live with requires the full participation of the borrower. But many borrowers in trouble practice denial — they don’t contact their servicer, and may not even respond if the servicer contacts them.
- Moral hazard. Investors are very concerned that if modifications are offered too easily or too early, some borrowers will pretend to need one who really don’t. This is a major reason investors restrict the discretion of servicers to modify contracts.
- Restrictions on servicers. Today, third-party servicing where the firm servicing the loan does not own it, is more often the rule than the exception. In the case of loans that have been securitized, it is always the case.
Investors restrict the discretion of servicers to modify loan contracts because their interests are different. Investors want modification only if the alternative is a more costly liquidation or foreclosure. They want to avoid early modifications that would later prove unnecessary, and they want to avoid encouraging borrowers to default who might not otherwise. Servicers, in contrast, want to protect their servicing fees, which they receive only from loans in good standing. Their general preference, therefore, is for early intervention.
A common contractual restriction on servicers is that modifications are permitted only for loans in default or for which default is imminent or reasonably foreseeable. Another is that any modification must be in the best interest of the investor. These create potential legal liability for the servicer. To be safe, some servicers limit modifications to loans already in default, which means 90 days delinquent or more.
Other impediments to loan modifications include:
- Scarcity of critically needed staff. Most interactions between mortgage borrowers and servicers are handled by computers and relatively unskilled employees. Borrowers in serious trouble are referred to a smaller number of more skilled and specialized employees. With the onset of the mortgage crisis, servicers were caught short of this critical but costly resource. While they now claim to have expanded their staffs to handle the workflow, a financial disincentive to adequate staffing remains.
- Mortgage insurance. On mortgages carrying mortgage insurance that go to foreclosure, investors are protected up to the maximum coverage of the policy, which is usually enough to cover all or most of the loss. This discourages modifications. Why do a modification for $15,000 if the $40,000 foreclosure cost is going to be paid by the mortgage insurer? Even if the insurance coverage falls short of the foreclose cost, the shortfall has to exceed the modification cost before modification becomes financially more attractive.
- Second mortgages. Many of the borrowers in trouble have two mortgages with different lenders, which complicates matters. The servicer looking to modify the first mortgage must make sure the borrower can afford both mortgages, and that the second mortgage lender does not upset the apple-cart by foreclosing. My mail from borrowers in trouble suggests that some servicers are prepared to invest some effort in working with second-mortgage lenders, and some are not.
- Lack of public disclosure. Nothing in connection with modifications is publicly disclosed except what servicers wish to disclose, which invariably is whatever presents them in a favorable light. There is no way for the public to know who is doing a good job and who isn’t.
Because of these impediments, modifications are making only a modest dent in the foreclosure problem. Other remedies will be discussed in a future article.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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