Why Loan Modifications Aren’t Happening

In previous articles I have bemoaned the fact that mortgage loan modifications have been proceeding at a snail’s pace. In a previous blog, I discussed the fact that loan servicers, the ones actually collecting payments and managing loans, may actually have a disincentive to do loan modifications and prefer to foreclose instead.

It gets more complex than that. You can see from this chart, courtesy of The Center for Responsible Lending, that loan modifications are being offered to about 10 percent of those who are seriously delinquent or headed for foreclosure.

That’s appalling, because those folks are the very ones (you would think) would benefit the most from modification. We would probably all agree that stemming the number of foreclosures would be better for the housing market. So why isn’t it happening?

Back to basics: Home values are a function of supply and demand. If there is an unusual increase in the supply of homes on the market compared with the number of buyers, value will decline. Put those homes in the hands of lenders who are just interested in salvaging something and moving along, and you can guarantee that those sellers will be happy with much lower prices than owners who are interested in maximizing the price they get.

You can see that with a larger number of foreclosures, the effect across a market can be devastating. So why wouldn’t lenders be interested in taking measures that would assure stable prices which would, ultimately, benefit them too? The answers are complex and deserve further discussion.

On the face of it, all lenders would say that they are interested in maximizing the values they get, but the plain fact of the matter is that the employees on the front lines are clerical employees who follow instructions. They have little interest in anything other than preserving their jobs. They certainly aren’t interested in big picture concepts such as maximizing values for the future.

Let’s consider the case of a lender that is looking at a number of loan modification requests. Let’s assume, for purposes of argument, that all requests are equal in terms of loan amount and that the current value of all homes is lower than the loan amount. On the face of it, you would conclude that all of the borrowers would be equally needy of an identical modification. You can also conclude that every borrower would welcome a modification, especially if it reduced his loan amount.

From the lenders’ standpoints, however, it looks different. What they know is that if they did nothing, a few houses would go into foreclosure; at the other end of the spectrum are other borrowers who, even if stressed, would keep making payments. The problem is that it is very hard for them to tell the difference between these two different classes of borrowers. It is even harder to differentiate between the ones in the middle.

So lenders looks at these borrowers and know that if they were to engage in loan modifications for borrowers in trouble, ones they could save from foreclosure, they would do it. So why don’t they?
 
The reason is simple. From a pure profit standpoint, the lender does not want to “give away” money by reducing the loan balances of people who would make the payments anyway. In a perfect world, they would offer loan modifications to all who genuinely needed them, but deny modifications to those who would make all payments even if no modification were to occur. But because they find it difficult to tell these people from the truly needy (the ones headed to foreclosure), it’s in the lenders’ best interest to do nothing.

I suspect that there are some number-crunching nerds at every lender who are evaluating exactly these types of situations and are telling management the financial implications of each potential strategy. 

There is another issue here that falls under the broad category of “moral hazard.” These same borrowers may also be categorized as to responsibility. Some borrowers acted responsibly and did not get into situations where they could not afford the home they were buying.

But we know of other borrowers, perhaps neighbors of those in the first group, who were reckless, who perhaps put no money down, and who got toxic loans that they really could not afford. It galls the American sense of fairness to come along and give some kind of “break” to those in the second class who, from an ethical standpoint, do not deserve preferential treatment.

I can assure you that those in the first class are outraged when someone suggests throwing a lifeline to the irresponsible members of the second class. This is yet another reason why progress is so slow and why the problems are getting worse.

Thus endeth the lesson.  

Randy Johnson – Author of How to Save Thousands of Dollars on your Home Mortgage and Savvy Borrower
articles, Randy is a mortgage broker who has financed over $1 billion
in properties. He writes about home buying and real estate finance
topics for CreditBloggers.com.

Tagged as: borrower, forclosure, housing market, loan modifications, loan servicer, loan servicers, loans, maximize home value, no money down, toxic loans, why the loan modification process is so slow

Randy Johnson Randy is a Credit.com contributor and seasoned mortgage expert. He writes about home buying, mortgage laws and real estate finance issues. He has financed over $1 billion in properties, is the author of How to Save Thousands of Dollars on your Home Mortgage and he is a feature columnist for Savvy Borrower.