The Problem with Loan Modifications

Over the past two years, many policymakers have identified loan modifications as key to fighting the mortgage crisis. The rationale for encouraging modifications appears quite simple: foreclosure is expensive for both the borrowers (who lose their home and their credit worthiness) and lenders (who often recover only a fraction of what they are owed). It would therefore seem that loan modifications — reducing payments so that owners can avoid foreclosure — are a potential win-win for both sides.

From that perspective, the slow pace of modifications appears rather mysterious, with potential causes including (a) stupidity on the part of lenders and servicers, (b) flaws in servicing contracts for securitized mortgages, and (c) borrower reluctance to even speak with their lenders.

Both the Bush and Obama administration have initiated a series of policies to encourage modifications, yet results have not lived up to expectations. The Washington Post has a nice article this morning that walks through one of the reasons for this failure. The basic problem is that the argument in favor of loan modifications focuses on only one kind of borrower: those who would make payments with some help but won’t make payments without that help. However, those borrowers are outnumbered by two other types: those who would pay without help and those who won’t pay even with help.

ForeclosureFrom the lender’s point of view, the economics of loan modification must consider all three types of borrowers. Modifying the loan of someone who would pay anyway is, from the lender’s point of view, a pointless giveaway. And modifying the loan of someone who is going to default anyway is just delaying the inevitable. Delay can be expensive, moreover, in an environment of declining house prices.

The WaPo story is based, in large part, on this recent paper from the Federal Reserve Bank of Boston. The authors summarize their findings as follows:

We document the fact that servicers have been reluctant to renegotiate mortgages since the foreclosure crisis started in 2007, having performed payment-reducing modifications on only about 3 percent of seriously delinquent loans. We show that this reluctance does not result from securitization: servicers renegotiate similarly small fractions of loans that they hold in their portfolios. Our results are robust to different definitions of renegotiation, including the one most likely to be affected by securitization, and to different definitions of delinquency. Our results are strongest in subsamples in which unobserved heterogeneity between portfolio and securitized loans is likely to be small, and for subprime loans. We use a theoretical model to show that redefault risk, the possibility that a borrower will still default despite costly renegotiation, and self-cure risk, the possibility that a seriously delinquent borrower will become current without renegotiation, make renegotiation unattractive to investors.

Update: On Tuesday, the Administration announced steps to encourage more modifications.

8 thoughts on “The Problem with Loan Modifications”

  1. Lesson: We should all be calling and requesting Loan Mods even if we don’t need them?

  2. They bailed out wall street but kicked homeowners to the curb with no place to live.

    They bailed out wall street but kicked homeowners to the curb with no place to live.

    I too am trapped in an interest only loan with America’s Servicing Company who obstinately won’t even send me the paperwork. If you are behind on payments they foreclose even IF they agree to a loan modification. They are unprofessional and unscrupulous. The government is doing NOTHING BUT….

    They bailed out wall street and kicked homeowners to the curb with no place to live. They are taxing the middle class to death. We have been abandoned.

    It is obvious this administration will do ANYTHING to help big business but will not help hard working Americans who want to stay in their homes and make their payments. For one thing the 31% of gross rule is absurd. For those in trouble, especially singles, their extravagant payments may already be at 31%. This is the case for me. BUT MY PAYMENT IS 55% OF MY NET.

    The servicing companies get kickbacks for loan mods. The banks get bailed out. The TARP benefited everyone but the homeowner. President Obama has let us down and now he wants us to pay for healthcare.I’m not saying it’s a good idea but with Americans homeless how can we consider a new tax boondoggle? Obama could have used TARP funds to bailout homeowners but stiff armed us away with complicated rules and regulations that no one can qualify for.

  3. So I received a call today from Wells Fargo that my loan modification was denied because my mortgage payment was less than 37% of my total monthly income. I explained to them that I have a 2nd mortgage, through Wells Fargo, that increase my mortgage to above 45 percent of my monthly income. There response was this . . . “We do not take your second loan into consideration when calculating your monthly mortgage. That is a seperate department.” I was floored! When I bought my home the 1st and 2nd loan came hand and hand. But now they are suddenly two seperate departments? Wells Fargo is a greedy, crooked company. Shame on them. Shame on the mortgage industry.

    1. Second mortgages really do muck up the modification process. I’d be interested to hear whether the Wells folks holding the second mortgage are willing to do anything for you.

  4. I hear ya. The programs that has been put out by both bush and obama’s administration have fell short of the expectation of the public. It goes to show that government can not fix all of our problems. I also write about mortgage frequently asked questions and answers at

  5. I don’t typically take the time to leave a comment, but this was especially helpful to me today. As I myself am in the midst of a loan modification, this is incredibly useful advice. Thanks!

  6. The Government helped out the big corporations, but who helps out the average man on the street? No one. Banks are dragging their feet with loan modifications. Why? Because if asset values go up, they wont have to show as big a loss. In the meantime, thousands of fine folks are losing their houses. We now reveal Insider tips to avoid foreclosures. Its a free report you can get at Save My House Tips.

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