If you’ve read it once, you’ve read it a thousand times. It’s the meme that it’s in the best interest of banks to modify loans and reduce principal since they will lose as much or more through the foreclosure process. Well, some fellows from the Boston Fed decided to see if that was indeed true, and guess what, it’s not the way the real world works.
Their study covers a lot of loans (60% of the mortgages originated between 2005 and 2007) and presents some conclusions that are not going to make anyone feel very comfortable about the housing market. Here is a summary of their findings:
1. Of the mortgages they reviewed only 3% had a modification that involved a principal reduction and only 8% received any sort of modification. That’s exceptionally low when you consider that half the loans they reviewed received foreclosure notices and 30% were actually foreclosed upon.
2. This one flies in the face of another piece of conventional wisdom. There was no statistical difference in the rate of modification between loans held privately and loans that had been securitized. Let me repeat that, no difference. After all the wailing about securitization as the evil spawn that stands in the way of homeowners getting a modification it turns out it makes no difference.
3. Now here is what they found with regard to the foreclosure versus modify thesis. I am going to excerpt their findings rather than paraphrase:
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 by market 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.
Before I add my two cents worth to this take a look at the implications that the Boston Fed group draws from their study:
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.
There’s little point in belaboring the obvious point here. The administration’s plans for mortgage modifications would appear to be much less achievable than they have, at least, indicated they would be. To the extent success in preventing foreclosures is part of their recovery plan this study might indicate that piece is at least in peril, which would of course render the rest of the plan somewhat less effective. So far as the mortgage market goes, it’s fair to assume that it is in for perhaps even a rougher ride than even the most pessimistic might have projected.
From a different perspective this is a reaffirmation of sorts to be careful about taking as gospel everything you read in either the MSM or the blogosphere. To all of us it’s a lesson we too often forget about assuming something to be true simply because it makes superficial sense. And to the administration and the bureaucrats who design these programs it should serve to caution them that what looks good in a D.C. committee meeting might not square with the real world.