Mortgage Lenders Conundrum of 'Less is More'

Who in their right mind would choose to receive substantially less on a debt owed rather than more? Confoundingly, this appears to be the particular province of a great many mortgage lenders, according to a recent study by the Office of the Comptroller of the Currency. But this is no mere miscalculation, but rather what appears to be grossly contrary to their best interests.

The numbers are truly staggering and rising. Last January, there were about 242,000 foreclosures in the pipeline, in May, 277,847, and in June, 281,560 were in process. A record 1.53 million properties entered the foreclosure process during the first six months of 2009. And, the loss severities, like foreclosures, have been steadily rising, too. In November, losses averaged 56.1 % of the original loan balance; in February, 63.3%; and based on almost 32,000 foreclosure sales in June, the average loan balance of $223,000 (when liquidated) fetched on average, $144,000 less a 64.7% loss. Perhaps no other single figure shows how wildly the mortgage mania inflated home prices. It also bodes ill for the quality of the mortgage- related assets residing on banks* loan portfolios.

Given losses like these, it is perplexing that lenders have been resistant to approve short sales and reluctant to do loan modifications with principal reductions. The 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. Yet, the losses incurred in foreclosure sales involving loans in the securitization trusts were a staggering $4.59 billion.   Hundred times more money was lost to foreclosures than would have occurred with principal reductions on loan modifications. This is stunningly irrational economic behavior!

The goal of Obama's Home Affordability Stability Plan (passed in February and enacted in March) was to encourage banks to effect loan modifications, but the plan has gotten little traction because participation was not obligatory for those banks on the receiving end of Troubled Asset Relief Program (TARP) funds. Mortgage modifications peaked in February and have declined in all but one month since. While servicers modified 23,749 loans in these trusts in February, they changed only 19,041 in May and 18,179 in June. Ironically, this is precisely when servicers were supposed to be hitting their stride with increasing numbers.

Loan modifications occur when a lender agrees to change the terms of a troubled borrower's mortgage. Most modifications involved the capitalization of arrearages into the balance of the loan thus leading to increased payments or lengthening the term of the mortgage known as forbearance. A less frequent approach is to reduce the loan's interest rate. A very rare one is to cut the amount of principal owed an option that could be of more help to a borrower because it means homeowners pay less money back to the bank over time.

If banks were to write down the value of these loans to the 40 cents on the dollar, their true value for these homes (based on what they are fetching as foreclosures), then why not reduce the loan amount outstanding for the troubled borrowers? This type of modification would have a better chance of succeeding than larding a borrower who is hopelessly underwater with yet more arrearages.

The seemingly incomprehensible reasons for lenders reluctance may be explained by a research paper by the Federal Reserve Bank of Boston that revealed why fewer than three percent of home- owners that were 60+ days delinquent had received a payment reducing loan modification. Some banks claim they would rather foreclose than offer loan modifications because they expect to recover more losses from a foreclosure versus a modified loan.

Many delinquent home owners, for example, "self-cure", that is, start paying again without assistance. The Fed found that an estimated 30% of all borrowers who miss two payments start repaying on their own. If the lenders had modified these loans, they would have lost money unnecessarily.
A second reason, according to the report, is that so many modified loans re-default, with up to 50% of all modified mortgages succumbing. This costs the banks twice. They bear the expense of the initial workouts and they pay again to finish the foreclosures, including any additional missed payments.

By postponing foreclosures, lenders say that they are forced to absorb subsequent losses in housing values. If the final repossessions are delayed a year , the lenders could be getting houses worth 10%, 20% or even 50% less than they were at the point of the original default. In which cases the banks would have been better off foreclosing. In addition, a borrower who faces a high likelihood of eventually losing the home will do little or nothing to maintain it, or may even contribute to its deterioration.

Given the above, there appears to be two sides to every story, but the anomalies remain unmitigated.

Copyright 2020 Rod Haase.  All rights reserved.