The Type of Modification Makes a Big Difference
December 22, 2008
"Do borrowers have any say over the type of loan modification they get? What kind of modification should they look for?"
Mortgage modifications are changes in the terms of a mortgage loan designed to make it more affordable to the borrower. Generally, modifications are available only to borrowers in default, or in imminent danger of default. The purpose is to cure or avoid the default, thereby avoiding foreclosure.
In general, borrowers must take the modification they are offered, since they have very little bargaining power. Their only card -- the implicit threat that if they don’t receive an adequate modification, they will default – is one they can’t play, at least not explicitly. However, borrowers can indicate what their needs are, and what the value of their home is, without it being perceived as a threat.
The major types of modification are discussed below in order of their cost to the investor and their value to the borrower.
The past due payments and perhaps late fees and other charges arising out of past delinquencies, are added to the loan balance. A new payment is then calculated which will be a little higher than the previous payment.
This is the most common type of modification because it has very little cost to the investor. Its only value to the borrower is that it gives him a new start by making him current. It works for a borrower who has hit a temporary rough patch and is now back on track, but not for a borrower who needs a lower payment.
A term extension is the payment reduction modification that is least costly to the investor. However, if a loan was originally 30 or 40 years and it is now only a few years old, the payment can’t be reduced very much this way. If the loan was originally for 10 or 15 years, a term extension to 30 years will reduce the payment materially, but 10 and 15-year loans comprise a very small share of loans in distress.
This is a more effective way to get the payment down. Cutting the interest rate on a 30-year loan from 6% to 3% will reduce the payment by about 30%, whereas extending the term to 40 years reduces it by only 8%. Rate reductions are flexible, since they can be adjusted to the needs of each individual borrower. They are more costly to the investor than a term extension, and correspondingly more valuable to the borrower.
To minimize the cost, rate reductions in some cases are made temporary. The modification may call for the original rate to be phased back over, e.g., 5 years. This presumes that the borrower’s payment capacity will grow over the same period.
On adjustable rate mortgages (ARMs) that are close to a rate reset date, where the new rate and payment will be well above the one the borrower is now paying, a modification can freeze the rate and payment at the current level. Many sub-prime loans have been modified in this way because they carried margins of 5%-7%, which when added to the current value of the rate index, would have resulted in substantial increases in rates and payments.
The mortgage payment declines in tandem with the balance. A 20% drop in the balance, for example, results in a 20% drop in the payment. Unlike a cut in the interest rate, however, a cut in the balance can’t be temporary, which makes it the most costly modification for investors, and the best modification for borrowers.
Balance reductions do have one major advantage for investors: they reduce the borrower’s negative equity, which increases the borrower’s incentive to do everything possible to keep the house. It is very plausible that re-default rates on loans that are modified with a balance reduction are materially lower than on other types of modifications.
New data compiled by the Office of the Comptroller of the Currency show that about half of all modified loans re-default within 6 months. I am told that breakdowns of re-default rates by type of modification will soon be available.
Modification decisions are made not by investors but by servicing agents under contract with investors, and the agents generally view balance reductions as a last resort. It is not in their own financial interest to cut balances because their servicing fees are based on the loan balance. A 20% cut in the balance also means a 20% cut in the fee.
Probably more important to their decision process, the initial cost of balance reductions is higher than that of rate reductions, which imposes a burden of proof on servicing agents to justify balance reductions to investors. Their argument has to be that a balance reduction has a materially lower probability of re-default, but so far only sketchy data have been available to support it. Hopefully, this will soon change.
ARM borrowers with reasonable margins, however, are not faced with this problem. Rates on most indexes used by ARMs are currently so low that many borrowers faced with an imminent rate reset will find their new rate is lower. For example, the widely-used one-year Treasury rate was about 1% in early December, 2008. An ARM that is indexed to that rate, and that has a margin of 2.25%, will adjust to 3.25%!
Even if servicers gave full weight to the impact of negative equity on re-default rates, there still wouldn’t be enough balance reductions because servicers will not take account of the social cost of negative equity. That’s why I believe that a Government program to reduce defaults by encouraging modifications should have Government share the cost of balance write-downs. See Breaking the Back of the Financial Crisis.
"Do borrowers have any say over the type of loan modification they get? What kind of modification should they look for?"
Mortgage modifications are changes in the terms of a mortgage loan designed to make it more affordable to the borrower. Generally, modifications are available only to borrowers in default, or in imminent danger of default. The purpose is to cure or avoid the default, thereby avoiding foreclosure.
In general, borrowers must take the modification they are offered, since they have very little bargaining power. Their only card -- the implicit threat that if they don’t receive an adequate modification, they will default – is one they can’t play, at least not explicitly. However, borrowers can indicate what their needs are, and what the value of their home is, without it being perceived as a threat.
The major types of modification are discussed below in order of their cost to the investor and their value to the borrower.
Capitalization of Arrears
The past due payments and perhaps late fees and other charges arising out of past delinquencies, are added to the loan balance. A new payment is then calculated which will be a little higher than the previous payment.
This is the most common type of modification because it has very little cost to the investor. Its only value to the borrower is that it gives him a new start by making him current. It works for a borrower who has hit a temporary rough patch and is now back on track, but not for a borrower who needs a lower payment.
Extension of the Term
A term extension is the payment reduction modification that is least costly to the investor. However, if a loan was originally 30 or 40 years and it is now only a few years old, the payment can’t be reduced very much this way. If the loan was originally for 10 or 15 years, a term extension to 30 years will reduce the payment materially, but 10 and 15-year loans comprise a very small share of loans in distress.
Reduction in Interest Rate
This is a more effective way to get the payment down. Cutting the interest rate on a 30-year loan from 6% to 3% will reduce the payment by about 30%, whereas extending the term to 40 years reduces it by only 8%. Rate reductions are flexible, since they can be adjusted to the needs of each individual borrower. They are more costly to the investor than a term extension, and correspondingly more valuable to the borrower.
To minimize the cost, rate reductions in some cases are made temporary. The modification may call for the original rate to be phased back over, e.g., 5 years. This presumes that the borrower’s payment capacity will grow over the same period.
Freeze the Interest Rate
On adjustable rate mortgages (ARMs) that are close to a rate reset date, where the new rate and payment will be well above the one the borrower is now paying, a modification can freeze the rate and payment at the current level. Many sub-prime loans have been modified in this way because they carried margins of 5%-7%, which when added to the current value of the rate index, would have resulted in substantial increases in rates and payments.
Reduction in Loan Balance
The mortgage payment declines in tandem with the balance. A 20% drop in the balance, for example, results in a 20% drop in the payment. Unlike a cut in the interest rate, however, a cut in the balance can’t be temporary, which makes it the most costly modification for investors, and the best modification for borrowers.
Balance reductions do have one major advantage for investors: they reduce the borrower’s negative equity, which increases the borrower’s incentive to do everything possible to keep the house. It is very plausible that re-default rates on loans that are modified with a balance reduction are materially lower than on other types of modifications.
New data compiled by the Office of the Comptroller of the Currency show that about half of all modified loans re-default within 6 months. I am told that breakdowns of re-default rates by type of modification will soon be available.
Modification decisions are made not by investors but by servicing agents under contract with investors, and the agents generally view balance reductions as a last resort. It is not in their own financial interest to cut balances because their servicing fees are based on the loan balance. A 20% cut in the balance also means a 20% cut in the fee.
Probably more important to their decision process, the initial cost of balance reductions is higher than that of rate reductions, which imposes a burden of proof on servicing agents to justify balance reductions to investors. Their argument has to be that a balance reduction has a materially lower probability of re-default, but so far only sketchy data have been available to support it. Hopefully, this will soon change.
ARM borrowers with reasonable margins, however, are not faced with this problem. Rates on most indexes used by ARMs are currently so low that many borrowers faced with an imminent rate reset will find their new rate is lower. For example, the widely-used one-year Treasury rate was about 1% in early December, 2008. An ARM that is indexed to that rate, and that has a margin of 2.25%, will adjust to 3.25%!
Even if servicers gave full weight to the impact of negative equity on re-default rates, there still wouldn’t be enough balance reductions because servicers will not take account of the social cost of negative equity. That’s why I believe that a Government program to reduce defaults by encouraging modifications should have Government share the cost of balance write-downs. See Breaking the Back of the Financial Crisis.