Mortgage Modification Reconsidered

My misgivings concerning the government's competence in macroeconomic policy have been reinforced by a pair of recent articles: an article in the Economist on July 9 reporting on a study by three Federal Reserve Board economists, and an article in today's Washington Post by Renae Merle, on modifying mortgages. Calculated Risk, the superb finance/economics blog, which specializes in real estate issues, has also reported on the Fed study. And the Wall Street Journal, in an article yesterday, reported Administration dissatisfaction with the progress of its mortgage-relief program.

The accepted wisdom, which undergirds the Administration's program, is that modification is a superior method, from a mortgagee's as well as a mortgagor's perspective, to foreclosure for dealing with a mortgage default, but that securitization of mortgages, by severing the relationship between the originator of the mortgage loan and the borrower, impedes modification and so contributed to the drop in housing prices and increase in foreclosures, two of the symptoms of the housing crash. One of the Administration's responses to the economic crisis, accordingly, is a program that went into effect in March to encourage modification of mortgages that are in default. The Administration resports that 200,000 mortgages have been modified since March, which is actually a small number relative to foreclosures.

The articles in question, and the Fed study, challenge the accepted wisdom. The study, the conclusions of which are reinforced by discussion with bankers and borrowers reported in the Washington Post article, found in a very large sample of residential mortgages that only 3 percent of seriously delinquent borrowers received a modification of their mortgage "that reduced their monthly payments in the year after they got into trouble" (the quotation is from the Economist's summary of the study), and only 8 percent of those borrowers received any kind of modification.

The reason is that mortgagees generally prefer either foreclosure or what they call "self-cure" to modification. They reckon that most delinquent borrowers will either resume their mortgage payments without a modification ("self-cure") or default irrevocably sooner or later, so that little is to be gained by a modification. The modification will (if meaningful) not only reduce the monthly payments received by the mortgagee, but also entail negotiation costs and, by postponing foreclosure, lower the price that the mortgagee will receive, either because house prices are falling (as they are now, and as Calculated Risk expects them to continue to be for the next year) or because the financially stressed homeowner will not maintain the house adequately, and it will lose value between modification and eventual foreclosure.

Of course, there will be some cases in which modification is preferable from the mortgagee's standpoint, but probably few; we do not know how many--if any--of the 200,000 modifications since March owe anything to the government's program.

The Fed economists' study found, surprisingly, no significant difference in modifications dependent on whether the mortgage had been securitized. One reason may be that the incentives to modify are very weak even if the mortgage originator still owns the mortgage. There are reports that the servicers of mortgage-backed securities do not have the staff to handle all the modification requests they are receiving, and this is plausible since these securities often pool thousands of mortgages. On the other hand, the banks that service these mortgages have large staffs; they may be discouraging applications for modification simply because they don't think the costs of processing them are worthwhile, given how few modifications are in a mortgagee's best interests.

It's nice to have the study, and no doubt it took months to complete. But that does not excuse the government's failure to have realized that modification may not have been the magic bullet that its mortgage-relief plan thought it would be, and securitization of mortgages may not have been the culprit in the housing crisis that it was thought to be. All that would have been necessary to get to the same conclusion that the Fed economists reached would have been to talk to a few mortgage bankers. Once again we encounter the government's surprising ignorance of the economy that it is trying to regulate. It's not as if the federal government is new to the mortgage market. The banking industry is deeply invested in that market and pervasively regulated by the federal banking agencies. We are in the presence of another striking failure of federal financial intelligence, in both senses of the word "intelligence."