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.
Loan
Modifications as a Substitute For Foreclosure
Mortgage contracts are
modified, at some cost to the investor, in order to prevent the
larger cost of a foreclosure later on. 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 and/or the interest rate
reduced. In cases where the property is worth less than the loan
balance, the balance may be reduced. For more, see
Mortgage Loan
Modifications.
The problem is that there are major
impediments to loan modifications.
Impediments to Loan Modifications
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.
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.
Copyright Jack Guttentag 2008