How will Modified Loans Perform?

In the wake of Obaba’s Homeowner Affordability and Stability Plan, many people are wondering if throwing a lifeline to borrowers will have its intended impact.

The big banks appear to like the plan.  So does Fannie Mae.  The market was mixed.  Bank stocks fell on the day, but overall, the Dow was about even. The Wall Street Journal’s Editorial Page is already coming out against the idea.

The doubt stems from research that shows that a high percentage of modified loans still end up delinquent, in default, and potentially in foreclosure.  John Dugan, Comptroller of the OCC, recently published research that shows that more than half of all loans modified in 2008 ended up in default.  The research only covered first lien loans.  So, that is some pretty challenging news for people who are hoping for a quick resolution to the foreclosure crisis.

Nonetheless, it may not be that simple.  This is because loan modifications are themselves something of an ill-defined event.  The assumption would be that the set of loan modifications made in 2008 would look like the ones proposed by Obama – where payments are aimed at about 31 percent of income.

On the ground, though, that is not what is happening.  The most prescient research on this topic is coming from a law professor at Valparaiso University in Indiana, Alan White.  He has looked at some of the agreements that are made under the banner of loan modification, and finds them wanting.  For example:

• In 98 percent of loan modifications, the mortgage principal was not reduced significantly (in contrast to parts of the Obama plan)
• In half of loan modifications, the borrower’s monthly payment was actually increased.

White looked at a sample of 4,300 loan modifications, on data made available through mortgage loan servicers.

He said that there were essentially three types of loan mods being made.  In the first, an adjustable-rate mortgage was transformed into a fixed rate plan.  This takes away uncertainty.  Its probably the kind of mortgage that most people should have had in the first place (fine for medical residents, investment bankers, and others with the expectation of future high income, or money at irregular intervals).  This would account for some loans that had higher payments.  Yet those “teaser-freezers” were only a very small percentage of all modifications.  The second was an interest rate reduction, but with no principal reduction.  This constituted about half of all modifications.   The payments are lower, but families still have negative equity.  The third route was capitalization of all arrears and missed payments.  New payments would have to be higher in order to satisfy the larger debt.

It is possible to see why so many of these modifications would have trouble.  Certainly, capitlization of arrears makes a tough mortgage payment even harder.  For the interest rate reduction, there is still the issue of negative equity.  That produces an incentive for borrowers to walk away from homes.  It is a situation where market forces compel an individual  to work against what is good for the whole.

All of this suggests that the naysayers should provide more context with their critique.  That, or perhaps, they should come up with a better plan of their own.