Critics of loan modifications are missing the larger point, and some evidence, too

A key part of the Obama administration’s Financial Stability Plan is the Making Home Affordable program, which encourages banks to renegotiate mortgages for the millions of homeowners facing the threat of foreclosure by giving subsidies to lenders.

These renegotiated, or modified, loans would ideally lower monthly payments to an affordable level so that homeowners can stay in their homes and banks do not have to take on the burden of managing a vacant property. However, some analysts at the Boston Federal Reserve have been challenging the notion that loan modifications are less expensive for banks than allowing a property to go into foreclosure. In particular, they claim that modifications only make financial sense to bankers for one segment of the lending population: those who can’t continue making their monthly payments, no matter how many sacrifices they make, but will not default on their mortgage after their loan terms are changed. Some borrowers may be able to find a way to continue making payments on their unmodified mortgage—what analysts call “self-curing”—while others may re-default on their mortgage, even after their loan has been modified. The conclusion is that, since the risk of self-curing or re-default is so high—there’s a 30% risk of self-curing and a 40% chance of re-default, according to the study— it is not in bankers’ self-interest to pursue loan modifications.
There are a few problems with this conclusion. First, most of the loan modifications made during the period studied by this report did not actually lower monthly payments. As the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision’s (OTS) Mortgage Metrics report points out, “Of the loans modified between January 1, 2008, and March 31, 2009, 45.5 percent reduced monthly principal and interest payments; 27.5 percent left payments unchanged; and 27.1 percent increased monthly payments.”
Why would loan servicers do that? Isn’t the point of changing loan terms to make them more affordable so the homeowner will actually be able to pay them off?
Servicers may have actually increased or held constant the payment amount in the hopes that the economy would pick up and the homeowner would be able to pay off their loan again, or the modifications may have been done without close attention to a homeowner’s ability to pay—as part of a systematic freeze of adjustable rate mortgages whose rates were about to go up, for example.
In any case, the obvious conclusion—that when monthly payments stay the same or increase for troubled homeowners, they’ll be more likely to default on their loans—turns out to be true. The OCC/OTS report notes, “The data presented in this section of the report consistently show that re-default rates were lowest and payments most sustainable for modifications that reduced monthly payments. Re-defaults were highest for modifications that resulted in no change or an increase in the monthly payment.”
Finally, the loan modifications done during this period tended to be granted to a different set of borrowers than the group the Making Home Affordable (MHA) plan is trying to reach. The OCC and the OTS note that “pooling and servicing agreements tended to allow modifications only for severely delinquent borrowers rather than allow servicers to work with borrowers who are current but facing an imminent default.” In contrast, the MHA program is aimed at homeowners who are not yet severely delinquent, but are in danger of defaulting. This group has a greater chance of staying current on modified loan terms. “The more serious the delinquency,” the report concludes, “The less likely the borrower will remain current after modification.”
In short, let’s not give up hope on loan mods. They are still the most important tool available to avoid the negative effects of foreclosures on our communities. If servicers were committed to modifying loans in a way that would be sustainable for the homeowner, re-default risk would be much lower—and, more importantly, families would be able to stay in their homes. Additionally, MHA gives servicers more flexibility by allowing them to modify loans for people who are not yet seriously delinquent but at risk of default. Loan servicers must keep their commitment made in Washington this week to make a stronger effort to modify loans sustainably for a greater number of people.
Finally, we must not lose sight of the larger purpose of avoiding foreclosure through loan modifications. It’s not just about what will make loan servicers the most money. As Adam Levitin at Credit Slips points out in his analysis of the Boston Fed report, “I wonder whether the goal of maximizing [value] for investors is the right metric.  A foreclosure might maximize value for investors, but be socially detrimental.  If the policy goal is improving social welfare, then we might want to discourage foreclosures that by themselves might be economical.” We must take more into account than loan servicers’ “cold-blooded profit maximizing” when we craft social policy. Staying the course with sustainable loan modifications will produce more stable communities—and that’s something that will benefit everyone.