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Why So Few Mortgage Modifications?

In Sunday's New York Times, Gretchen Morgenson wonders why loan modification rates have been so pitiful even though the government has stepped in to offer financial incentives for banks to undertake them. Morgenson interviews a law professor who expresses dismay over the fact that mortgage servicers seem to be acting against their own economic interests:

Given losses like these, Mr. White said he was perplexed that lenders and their representatives were resisting reducing principal when they modify loans. His data shows how rare it is for lenders to reduce principal. In June, for example, 3,135 loans — just 17.2 percent of the total modified — involved write-downs of principal, interest or fees. The total loss from these write-downs was just $45 million in June.

And yet, the losses incurred in foreclosure sales involving loans in the securitization trusts were a staggering $4.59 billion in June. “There is 100 times as much money lost in foreclosure sales as there was in writing down balances in modifications,” Mr. White said. “That is not rational economic behavior.”

If banks have written down the value of these loans to the 40 cents on the dollar that they are fetching on foreclosures — the only true value for these homes right now — then why don’t they bite the bullet and reduce the loan amount outstanding for the troubled borrowers? That type of modification would be far more likely to succeed than larding a borrower who is hopelessly underwater with yet more arrears.

So, what's going on?

A new working paper by Manuel Adelino, Kristopher Gerardi, and Paul S. Willen of the Boston Fed offers some insights.

Looking at data covering 60 percent of U.S. mortgages originated between 2005 and 2007, the researchers first find that the low volume of modifications can only be marginally explained by securitization. Many observers have worried that the slicing and dicing of mortgages among widely dispersed investors would make it difficult for servicers to renogotiate without the threat of a lawsuit, but the researchers say this doesn't seem to be the reason we're seeing so few modifications. Instead they point to a more "mundane" cause: that servicers believe they stand to gain more from a foreclosure than a modification. How can that be given Morgenson's concern above?

The answer is twofold. First, there's the "self-cure" risk that servicers face when they modify a loan. The researchers' data show that 30 percent of seriously delinquent borrowers wind up getting back on track with their payments "without receiving a modification; if taken at face value, this means that, in expectation, 30 percent of the money spent on a given modification is wasted."

The second explanation is "redefault risk"--the reasearchers find that a substantial fraction of borrowers who receive modifications are back in trouble again within six months, at which point the bank normally recovers even less than if they'd foreclosed earlier (due to falling home prices and poor upkeep). Which is to say, the number of easily preventable foreclosures is probably a lot smaller than previously thought.

--Zubin Jelveh