The Key to Successful Loan Modifications

As the Obama Administration’s Home Affordable Modification Program (HAMP) approaches its sixth month, the challenges facing the plan are becoming more clearly defined while solutions to those challenges remain a work in progress. At hearings held last week in Washington D.C. last week, the tone was that of frustration and confusion as to why there aren’t more modification getting done.

As the Obama Administration’s Home Affordable Modification Program (HAMP) approaches its sixth month, the challenges facing the plan are becoming more clearly defined while solutions to those challenges remain a work in progress. Admittedly off to a slow start, the program has about 175,000 loan modifications in its trial phase, according to Treasury officials. The trial phase of a loan modification is three month period where homeowners are granted lower payments while terms on the existing mortgage are modified. With 1.5 million foreclosure filings in the first half of the year alone the program needs to ramp up significantly before it can make a material difference in the foreclosure crisis.

At hearings held last week in Washington D.C. last week, the tone was that of frustration and confusion as to why there aren’t more modification getting done. Bred by that frustration, new plans were proposed and the rationale behind the foot dragging by lenders and servicers was hypothesized by industry insiders and analysts. Plans to turn foreclosed homeowners into renters and allowing for homeowners to put their homes back to lenders and demand reductions on their mortgage balances were a couple of ideas advanced by those convinced that the home loan modification plan that HAMP is based on has failed. Both plans still needed work to fill the gaping holes in logic behind them, as admitted by the designers of those plans.

Others, including economists at the Federal Reserve Bank of Boston, postulated theories on why banks are not embracing loan modifications whole heartedly. The Boston Fed’s new research suggests that the loan-modification effort may also be based on faulty economic assumptions. Their study basically refutes the idea of “everybody wins” loan modifications, based on the opinion that the process underestimates two of lenders’ strongest incentives to decide against modification. The first incentive is that, according to statistics, about a third of struggling homeowners “self heal” by finding new employment of making other financial adjustments like selling other assets. Since lenders have no idea which third of their portfolio is going to self heal they are willing to sit back and let situations play out instead of modifying the loan. The second disincentive is the high re-default rate on loan modifications. Again, according to the Boston Fed, banks are now looking at the historically high failure rates on modifications and deciding that they’re not worth the trouble. The summary of the Boston Fed economists is that, “the number of ‘preventable foreclosures’ may be far fewer than many believe.”

The problem with the theories proposed by the Boston Fed is that each disincentive carries a critical flaw; in the case of self healing homeowners, the flaw is that they’re using historical statistics that are based on a relatively healthy economy. Under normal circumstances, a homeowner may lose employment for a few months, fall behind on the mortgage, get re-hired, and then catch up on the missed payments. The odds for that kind of situation playing out in today’s economy are much lower with the national unemployment rate approaching 10% and certain states, like California, seeing jobless rates at 12%. Decreases in the average hourly work week are making it tougher on those that are unemployed as well. Executing loan modifications which lower payments in these situations makes sense for the lender, especially if the modification is tailored to the needs of the homeowner.

The second flawed piece of their theory is based on high default rates on modifications executed in 2008. As relatively new practice at that time, a high percentage of modifications didn’t lower payments at all and, in the case of negative amortization loans, actually raised them. Without payment reductions, it’s not a surprise at all that homeowners fell behind again after getting modifications that didn’t address the cause of the problem; mortgage payments that were too high relative to the homeowners’ income.

Contrary to the opinion of the Boston Fed and those looking for alternatives to loan modifications, there are loan modifications that are working and that can provide an “everyone wins” outcome, or at an least an outcome that inflicts the least amount of damage possible to all parties involved. The loan modifications which are working involve two changes; the first is a payment lowered by at least twenty percent. The second is a principle reduction on the mortgage balance, a relatively rare occurrence so far but one that is gradually proving out, especially when compared to foreclosure on the property.

While lowering the interest rates is now considered a “given” for a successful modification, principle reductions are now been seen as the key to successful modifications. With foreclosure sales bogged down with both over supply and limited demand, bids at auction are now coming in between 30 and 60% of the mortgage balances for the small percentage of homes that actually attract buyers. Weighed against a 40 to 70% haircut and a one in fifty chance that the home will sell, cutting a principle balance by 20 to 30% looks like a big win. The service continues to charges fees off (smaller) payment collections and the homeowner has a home that is once again affordable. With an economy that is redefining what a win looks like, making or losing less money might just feel like a big victory when compared to the alternatives.

There are some big issues that must be overcome so that loan modifications can play the role that the administration intends for them. Some are directly related to the process of getting a loan modification through the approval process such as hiring and training of staff and building the infrastructure to process reams of paperwork. The biggest obstacle at the moment, however, is an economy in recession which will trump even the noblest efforts in loan modifications by continuing to subtract jobs from the economy. A new focus on jump starting the economy with wide spread use of a proven loan modification formula could be exactly what everyone is looking for; a solution to the foreclosure crisis.

That will not be a welcome finding in the administration or in Congress where impatience with the pace of loan modifications is growing. But it is a message that policymakers cannot afford to ignore.

It’s still too early to pass final judgment on HAMP. Cleary the program and others like it are struggling in part because of the rising rate of unemployment, which makes it impossible for many people to pay any kind of mortgage, even a more affordable one. No doubt, as critics of the financial industry suggest, many services have been slow to train enough staff to do loan modifications and investors in mortgage-backed securities pose a lingering obstacle.

In short, say the Boston Fed economists, “the number of ‘preventable foreclosures’ may be far fewer than many believe.” That will not be a welcome finding in the administration or in Congress — where impatience with the pace of loan modifications is growing. But it is a message that policymakers cannot afford to ignore.

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