OCC Report Shows Mortgage Modification Trend And Woes

Yesterday, the Office of the Comptroller of the Currency and Office of Thrift Supervision released a report (opens .pdf) on mortgage metrics for the second quarter of 2009. As you might guess, it was not pretty. But it showed some interesting insights. I found notable the new trend in mortgage modification strategy, and its staggering re-default statistics.

First, I'd urge anyone with a keen interest in the mortgage market to at least skim the whole thing (opens .pdf), as I couldn't possibly capture all 46 of its pages in a blog post. But one of the most interesting trends I think it shows is that mortgages are being modified with greater attention to principal.

When modifying a mortgage so to try to prevent foreclosure, the borrower's monthly payment must be reduced. You can do that a few different ways, some of which include decreasing the interest rate and/or increasing the term. Both of those strategies can leave the loan principal intact, but still lower the monthly payment, making the loan more affordable. Those tactics also have been preferable to banks, as reducing the loan principal has been seen as a more extreme measure. Increasingly, however, that third option appears to be more prevalent.

As the chart below shows, in the first quarter of 2009 principal reduction was only used 3.1% of the time. In the second quarter, however, that percentage increased to 10%. That's a pretty drastic increase, with one-in-ten modifications now reducing principal.

OCC 09-09 Table 19.PNG

So what's the cause of this increase? It's hard to say. One reason might be that interest rate reductions and term extensions alone weren't enough to make the payments affordable for the borrowers. After all, you can only make interest rates so low or terms so long. The statistics in the above chart might support this, since interest rate reductions and term extensions have also increased over this period.

The OCC report suggests another reason why principal reductions might be a good idea:

Principal reductions reduce monthly payments as well as increase the equity in the home, which may contribute to the borrower's willingness to continue making payments on the loan.

Why is that willingness to pay so important? Because re-defaults are quite bad. The following chart shows the rates:

OCC 09-09 Table 3.PNG

They do seem to be improving slightly for Q2, but the statistics still show more than one-in-four borrowers receiving modifications from the first quarter has already re-defaulted just three months later. The chart also shows that over half of borrowers receiving modifications in prior quarters have defaulted again after a year. Such results indicate that these modifications are often grossly ineffective at preventing foreclosure.

More aggressive modifications, probably specifically lowering principal, will help those rates. This next chart shows that larger reductions in borrowers' payments result in fewer re-defaults (which probably isn't surprising):

OCC 09-09 Table 5.PNG

Yet, those numbers are still pretty staggering. Even if the payment is decreased by more than 20%, more than one-third of the associated borrowers have re-defaulted a year later.

And just for fun, check out this chart and associated graph. They show the vintage curves for these modifications and the resulting re-defaults.

OCC 09-09 Table 25.PNG

It's hard to tell if we're really seeing systematic improvement in re-defaults from this. But I suspect as banks and servicers continue to modify these mortgages aggressively, reducing principal, these re-defaults will improve. Yet, that improvement will likely be limited. I think it will be extremely difficult to get the year-later re-default percentage much below 30%, unless incredibly extreme payment reductions are made -- probably much greater than 20%.