"Who or what is responsible for the failure of the government’s mortgage modification program to make a sizable dent in the volume of foreclosures?"

Many factors are involved in this complicated story, but in my view, there are two major factors.

The deserving-borrower mindset

From the beginning, the operating premise of the government’s modification program has been that only deserving borrowers should be helped. The programs require that borrowers be suffering from financial hardship, and that their mortgage payment exceeds 31 percent of their income.

Balance reductions as a modification tool are discouraged or prohibited because they constitute a permanent benefit that can’t be retracted when the borrower is no longer suffering hardship.

And borrowers who don’t occupy their homes as their permanent residence are ineligible because they are investors looking for profit. Never mind that they are also major purchases of foreclosed homes.

The government is not always so discriminating in who it helps. When it rescued insurance corporation AIG from impending failure, for example, it also protected major Wall Street firms who were creditors of AIG from the losses they would have incurred had AIG been allowed to default — losses these creditors richly deserved.

This difference in treatment between Wall Street and Main Street reflected the difference in the challenge faced by policymakers. In the AIG case, they confronted a potential financial crisis that had to be dealt with immediately to avoid a catastrophe. Even if it were possible to design a plan that would have imposed losses on AIG’s major creditors while preventing a contagious loss of confidence generally, which is not at all clear, there wasn’t time to do it. The government couldn’t avoid benefiting the undeserving creditors of AIG.

Foreclosures, in contrast, have been viewed as a major problem, but not a crisis. Time was available for planning and deliberation, and out of that process emerged the rules designed to prevent undeserving borrowers from benefiting. This had the effect of disqualifying many borrowers, which was the purpose. But it also made the programs more complex to administer, aggravating dysfunction in the mortgage servicing industry, which resulted in many deserving borrowers not being helped.

Had the foreclosure problem been viewed as a crisis, the remedies fashioned would have been much simpler, implementation would have been much faster, and many undeserving borrowers would have benefited. But more deserving borrowers would have benefited as well, and the total impact could have been large enough to do the job.

Causes of servicing dysfunction

The firms servicing mortgages have been unable to cope with the enormous volume of modification requests that they have received. The results are well known to the borrowers and their advisers who have tried to get their loans modified. Borrowers have faced endless delays; an inability to reach the employee with whom they had their previous contact; conflicting stories from different employees who have been involved with their case; lost documents that don’t get reported back to the borrower; and on and on. The service is less terrible now than two years ago, but is still terrible.

Servicer dysfunction in connection with modifications has its roots in the prior history of the industry. The evolution of the industry was implicitly based on the assumption that the financial crisis, and the ensuing decline in home prices and rise in foreclosures, could not happen.

Separation of servicing and ownership: At one time, mortgages were serviced by the firm that owned them, but today a very large proportion is serviced by firms under contract with the owner.

This separation permitted servicing firms to reduce servicing costs by increasing volume, but it made government efforts to increase modifications more difficult because there were two parties involved instead of one. In general, under their contracts with owners, servicers are barred from taking any action that is not in the financial interest of the owners.

In attempting to encourage modifications, the government has necessarily dealt with servicers, but has had to take account of the servicers’ obligations to owners. This led the government to develop a net present value (NPV) rule that servicers apply to every modification.

If the application of the rule indicates that the mortgage will have a higher NPV to the owner with modification than without it, the servicer’s obligation to the owner is met. But the NPV rule is a complex step in an already complex process. Furthermore, because the NPV is calculated by the servicer and uses some servicer-specific information, there is no way for borrowers to know in advance if they will qualify for a modification.

Rationalization of servicing: The development of mortgage servicing as a separate line of business was accompanied by process changes designed to enhance efficiency. In general, this involved automating everything that could be automated, and simplifying functions that could not be automated so that they could be performed by relatively unskilled (and lower-paid) employees.

But modifications require a higher level of skills, which few servicer employees had. Of equal importance, servicers did not have the systems they needed for handling and routing inbound calls and faxes; for tracking files; for compiling and recording documents received from borrowers; for allocating responsibilities among staff; and so on.

In effect, servicers were on the beach with no protection when the modification tsunami hit them.

Next week: some recent developments affecting modifications.

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