"In modifying mortgages to make them affordable to borrowers, the loan balance is seldom reduced. Fannie Mae and Freddie Mac, in particular, don’t use balance reductions at all. Why is that?"

Your facts are right. The Mortgage Metric Report issued quarterly by the Comptroller of the Currency shows that 87 percent of the mortgages modified in the second quarter had their rate reduced, 51.4 percent had their term extended, but only 2.1 percent had their balance reduced. On loans owned or guaranteed by Fannie and Freddie, there were 10 balance reductions out of a total of 121,482 modifications.

Loans are modified by the firms servicing them, which in most cases don’t own the loans. They service them under contract with investors or their designees, and the contracts always stipulate that discretionary actions by the servicer, such as modifications, must be in the financial interest of the investor.

Hence, the quick and obvious answer to the question of why balances are not reduced more often is that the cost of balance reductions to investors is higher than the cost of term extensions and rate reductions.

Consider the borrower with a loan balance of $200,000 at 6 percent with 300 months remaining and an unaffordable payment of $1,289 that must be reduced to $1,000. This can be done with a rate reduction to 3.488 percent, a rate reduction to 4.337 percent combined with a term extension to 360 months, or a balance reduction to $155,206.

Term extensions cost the investor very little, but in most cases don’t reduce the payment by enough to make it affordable. In the example, the payment cannot be reduced to $1,000 by a term extension alone.

A rate reduction is more costly than a term reduction, but less costly than a balance reduction. The reason is that the cost of a rate reduction is spread over the remaining life of the loan and terminates if the loan is paid off before term, as most are. The loss from a balance reduction occurs immediately and is not retrievable. For example, if the loan at issue is paid off one month after the modification, the investor recovers almost $200,000 after a rate reduction but only $155,000 after a balance reduction.

But the proposition that a balance reduction costs more than a rate reduction has an important proviso: The risk of default must remain unchanged. In fact, we know that if the borrower has negative equity, a balance reduction will reduce the risk of default by more than a rate reduction. We would thus expect that a rational loss mitigation policy would employ balance reductions on loans with significant negative equity.

We see this on loans serviced by firms that own the loans they service, called "portfolio lenders," who are not exposed to the potential legal liability of firms servicing for others. Some 15.5 percent of the modifications by portfolio lenders involved balance reduction. While these lenders accounted for only 13.4 percent of total modifications during the second quarter, they did 96.7 percent of the modifications involving balance reductions.

While there are no data on this, it is plausible that portfolio lenders use balance reductions in cases where borrowers have significant negative equity. In such cases, making the payment affordable by reducing the balance also reduces the risk of default, relative to the same payment reduction achieved through a rate reduction. The purpose is to reduce losses, and there is a strong presumption that portfolio lenders know what they are doing.

Why don’t other servicers do the same? Portfolio lenders are responsible only to themselves, whereas firms that service for others may fear that they will have difficulty justifying balance reductions to investors. However, that doesn’t explain the absence of balance reductions on loans serviced for Fannie Mae and Freddie Mac, who set very explicit rules for servicers. Investors who own mortgage-backed securities issued by the agencies are insured against loss, so fear of liability can’t be a factor.

My surmise is that the complete avoidance of balance write-downs by the agencies reflects a fear that balance reductions encourage strategic defaults — borrowers walking away from their mortgage because it is larger than their house value.

Fannie Mae, in particular, has taken a hard line on strategic defaults, declaring that any borrower who did it would be barred from taking another Fannie loan for seven years, and threatening to pursue such borrowers for deficiencies in states where this was possible.

In my view, the fear that balance reductions will encourage strategic defaults makes little sense. The immediate impact is bound to be just the opposite — cutting the balance reduces the gain from a strategic default, and therefore should reduce their number among those obtaining loan modifications. That is rational behavior.

In principle, this could be offset by more strategic defaults among those not receiving modifications. However, that requires that some such borrowers who would not have defaulted do so solely because borrowers receiving modifications have had their balances reduced. That is irrational behavior.

If portfolio lenders are correct that in selected cases balance reduction modifications will reduce their losses, and I believe they are, the agencies are missing a chance to reduce their losses, which are borne ultimately by taxpayers.

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