Why Your Mortgage Has Not Been Modified

Last year I wrung several good posts from the Obama Administration’s doomed-from-go scheme to get banks to modify mortgages. It was good material for me. I got to mock both those few who were clueless enough toVA_house think it might work and the great many people who were too polite or too loyal to the White House to admit that they understood that the program’s outlook was grim.

After a while, I got bored of beating that particular dead horse. So many other things to mock.

But I realized recently I never really addressed the basic conceptual flaw in the Home Affordable Modification Program. This came to me as I was reading a recent guest post at Smart Spending, a blog that carries many thoughtful guest posts.

Why Don’t Banks Modify More Loans? Asks why, three years into the crisis and despite a big government program and lots of media buzz, mortgage modification remains such an exceptional event. The author, Marilyn Lewis of MSN Money, gives, somewhat half-heartedly, three theories that might explain the conundrum. All focus on the awkward mechanics and incentives of mortgage servicers.

As everybody ought to understand by now, the companies responsible for collecting payments from homeowners and, as necessary, negotiating with them, do not generally own the mortgages in question. Lewis refers to them as “banks” in her title, and they are often also in the business of banking, but in this context they are merely agents. And they are agents not for a single owner but a complex group of owners with differing claims on a pool of mortgages.

So a mortgage servicer is in a very difficult position when it comes to renegotiating the terms of a mortgage. It is their job to deal with the consumer, but it is ultimately not their money. Any mortgage modification is liable to be the subject of a lawsuit brought by one of the mortgage owners who thought the new deal too generous to the consumer. On the other hand, since the servicer does not own the mortgage, a default is not a total disaster for them. Thus, they have less incentive to go out on a limb to fix a loan in trouble.

Lewis brainstorms some alternate theories. The servicers may actually get more fees by delaying action. Or they are swamped by the volume of problem mortgages and just do not have the manpower to work through them. Or, much less plausibly, they are stringing the process out, hoping for a better deal from the government.

There are some real problems with the mortgage servicer model, but as explanations for why loan modifications are not more common they miss the point by begging a question. How many homeowners are plausible mortgage modification candidates to begin with? The answer is not very many.

Consider the several factors that need to line up in order for a modification to make sense. First, the house needs to be underwater, that is, the mortgage balance must be more than the value of the house. If a borrower defaults on a mortgage worth less than the house then the bank can foreclose and be made whole. So it would not make sense to forgive any of the debt on an above-water house, even if the borrower could no longer make the payments.

Once nearly unheard of, underwater homes are a relatively common situation today. But, it is worth pointing out, they are not universal. Most homeowners are not underwater.

Second, the homeowner must be unable to make the payments on the current mortgage. This situation is often unhelpfully conflated with being underwater. Of course, it is a (mostly) unrelated phenomenon. Underwater homeowners may now bitterly resent the monthly payment, but the great majority can afford it just as easily as they could back when the house was worth more.

A Venn diagram that intersects “underwater” and “can’t make payments” would not leave a particularly large ovoid of intersection relative to the general population of mortgages. But there is a third circle to draw that will leave just a tiny triangle. To be a candidate for modification, a homeowner needs to be underwater, unable to make the current payments, and able to make the payments on a mortgage for a sum equal to the current house value.

Since the bank can realize the value of the house by foreclosing, it would be irrational to forgive debt below that level. Conversely, it would make no sense to reduce the mortgage balance if the homeowner still could not make the payments.

Most of the potential mortgage modifications we are talking about, a reduction in principal to the point that the house is no longer underwater, are not that large, perhaps in the 20% to 30% range. Yes, there are those for whom a 30% reduction in the mortgage payment is the difference between solvency and bankruptcy, and there are some houses that are 50% underwater, but these are comparatively rare occurrences. (Of course, all homeowners wouldn’t mind a 30% mortgage reduction. But the criterion here is that they need one, that without it the loan will go into default.)

My intuition tells me that this situation, a homeowner who can almost-but-not-quite afford the mortgage, is pretty rare. More likely, they can either make the current payments with some belt-tightening or they can’t really afford the house even at the newly reduced price.

So just how many mortgages are in the center of this Venn diagram? I will leave it to others to run the numbers, but off the top of my head I am thinking less than one percent of them. Which turns out to be roughly in line with the volume of modifications that manage to make it through the ill-suited servicer system.

In January I wrote that the few who thought HAMP would work were blinded by ideology. I still think that is true, but there is another, less partisan, bias at work here. It is the natural wishful thinking that there must be some happy middle ground, that if borrower and lender could just sit down and discuss the situation reasonably they could work something out. Alas, not so. The mortgage crisis was just as bad as we feared.

The core problem is not that those charged with performing modifications are reluctant to do it, or even that they are just bad at it. The principle reason that the number of mortgage modifications is falling so far short of expectations is because those expectations were unrealistic.

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