States' Settlement With Banks Pushes Mortgage Modifications

Late Monday, a draft settlement (.pdf) was leaked, which was offered by the state attorneys general to banks for cases alleging their failure to properly process foreclosures. It contained 27 pages of demands for changes to the foreclosure process by the state attorneys general. In essence, the settlement serves as a road map for how these officials would like to see the process reformed. Various steps are taken in terms of communication, verification, and other measures to ensure the foreclosure process is fair and clear. But the document also calls for banks to make more mortgage modifications to prevent foreclosures.

Cheyenne Hopkins from American Banker has a really good cheat sheet on the hard-to-read settlement. She explains many of the demands that the states have surrounding mortgage modification. Let's go through some of them.

Empowering Investors

Under the term sheet, servicers must offer a modification when it will result in a greater net present value than foreclosure. If a borrower requests a modification and the servicer believes that a pooling and servicing agreement prevents one, the servicer must still perform a net present value test and, when positive, present that to trustees or other authorized parties in order to obtain consent for a modification.

The net present value test is not new to servicers. This has been the standard under which most modifications are considered, including the government's Home Affordable Modification Program (HAMP). The problem this provision intends to solve is when servicers immediately deny a modification, because it claims the legal documents that govern the ownership of a mortgage forbid modification. In those cases, the settlement would require servicers to perform the test anyway, and then provide the results to the parties who control ownership of the mortgage.

This could be a significant change. In January, a mortgage investor industry group indicated that it supports more aggressive modifications and fewer foreclosures. That even includes principal reductions. If presented with more opportunities to allow struggling borrowers to modify their foreclosures, investors may consent.

Checking Their Work

The servicers must present their models for determining a net present value to the Consumer Financial Protection Bureau upon request.

Some critics have complained that servicers can choose very conservative assumptions for these tests, which will generally result in a negative net present value and cut the number of modifications they must perform. Presumably, the CFPB would penalize these servicers if it finds that they are intentionally choosing overly conservative assumptions for the expressed purpose of avoiding modifications. This could also potentially prevent more foreclosures.

Reducing Principal First

Servicers are pushed to consider principal reduction as a first option when possible, although the term sheet makes it clear that the subject has also been "reserved for further discussion." Servicers must evaluate certain delinquent loans with a loan to value ratio of greater than 100%, and offer principal reduction if that would result in a better net present value than a standard modification.

Up to now servicers have largely complained that principal reduction will result in a bigger losses than other modification strategies like cutting the interest rate or extending the term of a mortgage -- or foreclosure. But again, the assumptions here matter, and the settlement provides some guidelines here. It says that the parties must agree on the assumptions used, including the presumed redefault rate.

Presented by

Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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