Mortgage Modifications

Ten years from now, I think we'll all finally realize that we spent the last decade living during the largest real estate roller coaster ride of all modern times. And those of us who live in San Joaquin County probably will have had the biggest roller coaster ride of all. We've gone from one of the most affordable markets in California to the one of the least affordable markets in the country and now we'll likely end up again as a great low-cost alternative to the coast.

In the meantime, this vicious roller coaster ride has left us with one of the largest foreclosure rates in the country, which likely means one of the largest foreclosure rates of all time. While the pace has slowed lately, there is fear that the foreclosures are about to pick up again after a government-forced slowdown in repossessions. One of the reasons that the government (both state and federal) mandated this slowdown was under the false assumption that it would give homeowners more time to renegotiate their terms with their lender. A recent study has shown that fewer than 10 percent of all mortgages have been modified.

Many blame the lack of modification on the fact that so many of our mortgages were sliced, diced, and then sold off to investment pools all around the country. In reality, the data indicates that the lack of loan modification is likely due to the fact that most of the loans still wouldn't work out for the homeowner. I believe this is particularly in the states that experienced the greatest drop in prices, and the data supports that. When a house is worth half or less of the original loan amount, the lender will likely opt to resell the property in the future.

USC professor Richard Green's recent study (click here) does a great job of explaining the paucity of modifications:

Since we conclude that contract frictions in securitization trusts are not a significant problem, we attempt to reconcile the conventional wisdom held by market commentators, that modifications are a win-win proposition from the standpoint of both borrowers and lenders, with the extraordinarily low levels of renegotiation that we find in the data. We argue that the data are not inconsistent with a situation in which, on average, lenders expect to recover more from foreclosure than from a modified loan. At face value, this assertion may seem implausible, since there are many estimates that suggest the average loss given foreclosure is much greater than the loss in value of a modified loan. However, we point out that renegotiation exposes lenders to two types of risks that are often overlooked bymarket observers and that can dramatically increase its cost. The first is “self-cure risk,” which refers to the situation in which a lender renegotiates with a delinquent borrower who does not need assistance. This group of borrowers is non-trivial according to our data, as we find that approximately 30 percent of seriously delinquent borrowers “cure” in our data without receiving a modification. The second cost comes from borrowers who default again after receiving a loan modification. We refer to this group as “redefaulters,” and our results show that a large fraction (between 30 and 45 percent) of borrowers who receive modifications, end up back in serious delinquency within six months. For this group, the lender has simply postponed foreclosure, and, if the housing market continues to decline, the lender will recover even less in foreclosure in the future.

We believe that our analysis has some important implications for policy. First, “safe harbor provisions,” which are designed to shelter servicers from investor lawsuits, are unlikely to have a material impact on the number of modifications and thus will not significantly decrease foreclosures. Second, and more generally, if the presence of self-cure risk and redefault risk do make renegotiation less appealing to investors, the number of easily “preventable” foreclosures may be far smaller than many commentators believe.

So basically, about 80 percent of those who defaulted could either make their current loan payment or are never likely to keep up their payments, thus leaving a small group to work with. Hopefully our federal and state policymakers will figure this out and stop trying to manipulate the market. The sooner we can get the foreclosures sold off, the sooner we can start stabilizing the real estate market.