Avoiding foreclosures

Avoiding mortgage foreclosures ought to be a win-win proposition for the lenders and borrowers directly involved. It would also be good for the rest of us--for anybody with a stake in the housing market, or an interest in a faster economic recovery. When you recall that it was identified very early on as a key aspect of managing this crisis, it is disappointing that so little progress has been made, and the reasons for this are not altogether clear. Securitization has complicated the loan-modification process, of course, but even so.

Sheila Bair's plan seems to be making some headway. Will it work? It was tried when the FDIC took over IndyMac, and with some success. Still, the numbers are not exactly shattering.

IndyMac, which services 653,503 loans, has offered about 23,000 modifications since launching the programme on August 20. Only 5,108 have been completed with first payments made but this is double the figure a month ago and will grow rapidly as modifications in the pipeline are finalised.

Given the lack of effective alternatives, it seems worth trying on a larger scale. True, it creates an incentive to default (only delinquent loans are eligible for help), but this is true of any loan-modification scheme. A bigger problem is that it does not seem to provide for principal write-downs as opposed to interest-rate relief. For why that might matter, here is Ben Bernanke (from a speech last March) on the subject.

To date, permanent modifications that have occurred have typically involved a reduction in the interest rate, while reductions of principal balance have been quite rare.  The preference by servicers for interest rate reductions could reflect familiarity with that technique, based on past episodes when most borrowers' problems could be solved that way.  But the current housing difficulties differ from those in the past, largely because of the pervasiveness of negative equity positions.  With low or negative equity, as I have mentioned, a stressed borrower has less ability (because there is no home equity to tap) and less financial incentive to try to remain in the home.  In this environment, principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.

Lenders tell us that they are reluctant to write down principal.  They say that if they were to write down the principal and house prices were to fall further, they could feel pressured to write down principal again.  Moreover, were house prices instead to rise subsequently, the lender would not share in the gains.  In an environment of falling house prices, however, whether a reduction in the interest rate is preferable to a principal writedown is not immediately clear.  Both types of modification involve a concession of payments, are susceptible to additional pressures to write down again, and result in the same payments to the lender if the mortgage pays to maturity.  The fact that most mortgages terminate before maturity either by prepayment or default may favor an interest rate reduction.  However, as I have noted, when the mortgage is "under water," a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure.