Loan Modifications Not Panacea for Borrowers

With an estimated 20% of American homes valued at less than their mortgage balances and a double-digit unemployment rate, defaults and foreclosures are predictable. Current data of the Mortgage Bankers Association indicate that between 4% and 5% of all U.S. mortgages are in some stage of the foreclosure process, with another 10% in nonforeclosure delinquency. Still, the government's principal modification program-the Home Affordable Modification Program-is not even close to achieving its announced goals.

Traditionally, loan modifications took the form of temporary forbearances, structured on the assumption that the borrower's difficulty making his monthly payment was also temporary-based on a lost job or illness, for example. The expectation was that the borrower would get another job, or recover, and again be able to make loan payments. Borrowers with structural payment problems, such as permanent loss of income, could not be helped.

In areas suffering from severe economic problems, lenders might continue temporary forbearance for years to avoid losses resulting from foreclosure sales into weak real estate markets. But even in these cases, permanent modifications with permanently lower payments or reduced principal balances were rarely available.

In the situations described above, the modification process was relatively informal, without the massive documentation required by HAMP. The process was usually initiated by a motivated borrower who wanted to preserve his home, was willing to make substantial sacrifices to do so, and was often grateful for the lender's willingness to delay enforcement and foreclosure.

By contrast, the federal loan modification program is rigidly structured and features permanent rate reductions and sometimes principal reductions. It is designed to resolve defaults on loans that were unaffordable for the borrowers to begin with. The traditional solution for a structurally unaffordable loan is to get the consumer out of the home, whether by foreclosure or short sale. It is not to preserve homeownership by putting the loan through HAMP's Procrustean solution by shrinking payments to fit the borrower's income. While high loan costs may have caused some defaults, particularly earlier in the financial crisis, fewer recent defaults appear to be caused by underlying loan origination problems, and HAMP appears ever less appropriate to resolve current delinquencies.

Moreover, while some HAMP modifications are initiated by borrowers, it is just as likely that servicers are the parties attempting to pull borrowers into the HAMP process. Because of the intense political pressure the federal government has put on servicers to implement HAMP modifications, servicers, rather than borrowers are driving the process.

Interestingly, private investors not forced by the government to participate in HAMP (and who modify loans for their own accounts) rarely follow the HAMP model. Some are offering borrowers very low payments to enable them to maintain homeownership through the real estate downdraft while expecting to reinstate loan payments later, when wages and employment are stronger. Others are offering substantial principal reductions in order to allow borrowers to refinance out of their loans.

In addition to homeowners facing financial difficulties, an increasing number are deliberately defaulting, even if they can afford to repay their loans. Morgan Stanley estimates that "strategic defaulters" accounted for 12% of loans in default in February 2010. Interestingly, Morgan Stanley's report also found that mortgagors with higher credit scores and larger loan balances were more likely to deliberately default. Strategic defaulting is said to have a "contagion effect," meaning a homeowner is more likely to deliberately default if he knows others who have. Strategic defaulting has other pernicious effects, too. Freddie Mac says strategic defaulting leads to home price deterioration. Strategic defaults, when added to the defaults of those who simply cannot pay, could lengthen a long-delayed housing recovery.

Also delaying the housing recovery are state foreclosure moratoria and requirements such as "foreclosure mediation." As loans become ever more delinquent, foreclosure delays rarely result in reinstatement and retention of homes. Rather, delays allow borrowers to continue living in mortgaged homes without payment, often while their homes physically deteriorate. This eventually discourages neighboring homeowners who are keeping up with their payments.

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