Everyone knows that hindsight is a wonderful thing.  Now our friends at the Federal Reserve Bank of Boston have issued a voluminous study of mortgage modifications during 2008.  Until October 2008, the financial crisis had not reached full bloom.  However, the study is extremely insightful into the rational behavior of banks and why mortgage modifications, up until now, have been something of a failure.

First and foremost, the study validates the fact that principal balance reductions in mortgage modification were truly an urban legend.

How mortgage modification shops were set up to influence individuals into thinking that they could get massive reductions in principal is beyond me…

However, at least for 2008, the verdict is now in.  Only about 1.3 percent of all mortgage modifications included any principal reduction at all.  Frequently, mortgage modifications have included increases in the outstanding principal balance.  In fact, in the third and fourth quarters of 2008, principal balance increases occurred on 70.9 percent and 61.5 percent of all loans respectively.

What did occur, however, is there were indeed meaningful reductions in the monthly outlay that individuals had on their particular mortgages because of increasing the term of the loans as well as substantially reducing the monthly interest due on the loan.  Thus, the average loan that was modified in the third and fourth quarter of 2008 saw a 21 percent reduction in monthly payments.  In a few cases, however, approximately 6 percent of modifications during that same period actually saw an increase.

Now it is very important to understand that in 2008 President Bush was still in office and President Obama had not yet implemented any of his financial stimulus packages.  Thus, anecdotally, we are now starting to see, on occasion, principal reductions in certain modifications.  Certainly, the number is well in excess of 1 percent, but is not something that is occurring on every loan with any certainty.

Policymakers and individuals frequently do not understand why banks are so reluctant to reduce the principal balance of a loan to the value of the property.  I always thought that the reason was that the banks were concerned about creating a contagion of individuals who possibly could afford to pay their mortgage, but have decided to seek modification because they don’t feel it’s fair that their neighbor is getting a modification while they are not.

In fact, as previously discussed in my prior blog about foreclosures and social networks, researchers have distinguished “strategic foreclosures” to be when an individual walks away from their home because it does not make economic sense to continue making payments when the property is underwater. While the term does not exist in the area of mortgage modification, perhaps banks are concerned about continuing to modify too many loans thereby unwittingly encouraging “strategic modifications.”

In fact, a bank’s decision to not embrace modifications is actually quite simple, yet it lurks beneath the surface…

Loan Modifications and Decreased Values
First and foremost, the reason many banks chose not to embrace modifications was that property values were going to continue to erode and decrease.  Under such circumstances with knowledge that many such modifications would fail, the bank would net even less money than they would if they brought the foreclosure immediately.  Thus, the banks thought they should just get it over with, take the medicine and this would leave them in better shape than if they allowed for a modification that then subsequently failed.  The fact of the matter is that, certainly in the past year, the banks were not wrong in that prices have continued to fall and thus by doing a quick foreclosure they would be in better shape than allowing the property to linger and continue to deteriorate in value.

Loan Modifications and “Self-Curing”
The second reason that the banks were reluctant to conduct modifications is because they felt that they would be shooting themselves in the foot.  Specifically, the banks know that a fairly decent percentage, as much as 30 percent of all loans that are in default, will “self-cure” and bring themselves back into compliance— meaning that they will no longer be in default.  Obviously, if the banks decided to modify an entire portfolio of mortgages they would lose the opportunity to receive the additional income from those mortgages or individuals that decided to self cure their default.  When the bank factors in the loss of “self-curing” mortgages their loss is much higher than when they decide to only modify certain loans and then anticipate that other loans may indeed “self cure.”

The problem with the self-cure analysis is that it is based on an economic environment where equity in homes historically had not fallen more than 20 percent below the mortgage amount.  As discussed previously we are now in an environment’ where many homes are as much as 50 percent underwater and the idea of self-cure is highly unlikely.

The Feds paper concludes, that “if the presence of ‘self-cure’ risk and re-default risk do make renegotiation less appealing to investors, the number of easily ‘preventable’ foreclosures may be far smaller than many commentators believe.”

Thus, it is still my contention that if the government wants to deal with the foreclosure crisis and make sure that it does not continue to get worse and become a contagion, that the focus must be on restoring an orderly pricing structure to the market by providing the proper incentives to individuals and investors to come back into the market and re-stabilize the housing market.  Like any market, if there are too few buyers and too many sellers, prices will continue to decrease.  If we are able to bring more buyers back into the market prices will stabilize, the number of defaults will decrease, people will be more reluctant to walk away from their homes, the number of foreclosures will no longer increase, and what economists call a “negative feedback loop” will finally be stopped in its tracks. And guess what? The banks will no longer be afraid to modify loans.

For more information view my video interview about banks and mortgage modifications.

Roy Oppenheim