The Mortgage Modification Mess

Another session I attended today at this week's ASF conference focused on the mortgage modification effort, both by the U.S. Treasury's HAMP program and banks privately. It's not going so well. The panelists generally appeared to agree that borrowers who are underwater or have second liens are mostly doomed to foreclose. But some believe the key might be for principal reductions to become more prevalent.

The panel's only government representative, Seth Wheeler, Senior Advisor in the Treasury leading the mortgage modification effort, believes the program is doing fairly well right now. Even though he says its success rate thus far hasn't shown that very clearly, he sees a large number of modifications being made permanent in the months to come. According to Wheeler, about 75% of the over 900,000 borrowers who have received trial modifications are making their payments. So if they can get all their documents in, then that would amount to quite a lot of permanent modifications.

Of course, those who receive trial modifications, in theory, should be able to bring them permanent. There are underwriting standards that dictate who gets into the program in the first place, and many borrowers are turned away if it isn't believed that they would even be able to make payments on a reasonably modified loan. So how many HAMP trials that are made permanent doesn't exactly speak to the success of preventing foreclosures in a broader context.

For a more complete picture, we can turn to Doug Potolsky, another panelist who works with modifications at Chase Home Finance. He explained that HAMP is only one option for troubled homeowners. Chase offers other modification programs of its own. According to Potolsky, Chase's pull-through rate for modifications is only around 20% -- and that would include those loans that can apply for the HAMP program and the bank's own programs.

Laurie Goodman, Senior Managing Director at Amherst Securities Group, noted one of the major problems: so many homeowners remain underwater. She revealed a number of startling statistics about how unlikely underwater homeowners are to bother trying to save their home from foreclosure once they've gone delinquent. Once underwater homeowners miss that first payment, they strategically reevaluate whether they should continue to pay. According to Goodman, at that time there's a 75-80% likelihood of the mortgage's default in the coming months. If the borrower has positive equity, however, the rate of default is much lower.

An additional problem was explained by Nancy Mueller Handal, Managing Director of Structured Finance at MetLife. She focused on the second lien problem. If borrowers are also trying to pay off a second lien, like a home equity loan, then the likelihood of a modification's success also plummets. Unfortunately, she says that there's no great solution to the second lien problem. This is just a situation where borrowers have more debt than they can handle. Goodman chimed in with a scary statistic: 51% of non-agency borrowers (those whose mortgages aren't owned or guaranteed by the government agencies like Fannie Mae and Freddie Mac) have second liens.

What's the solution? Goodman and Mueller Handal both agreed that principal forgiveness is the only way to prevent foreclosure for these borrowers. While this certainly isn't a new suggestion, it's a proposal that's beginning to gain more support. We're at the point where it's become pretty obvious that nobody wants to pay a mortgage for more than their home is worth. The easy solution would just be to rewrite the mortgage for a value more in-line with the home's current value.

There are a few problems with this. The most obvious is the moral hazard involved. If people made poor decisions to purchase a home they knew they couldn't afford, principal reduction would sort of act as their reward. At least if they are forced to foreclose, there's a consequence for their bad behavior of losing the house and their credit score taking a big hit. Yet, what about the borrowers who aren't entirely to blame for their inability to pay, because they got sold a bad mortgage by a unscrupulous mortgage broker? Should they suffer the same consequences?

Of course, banks have yet to jump on the principal reduction band wagon. As I've noted in the past, this would cause banks to immediately take deep losses on that principal. By creating these modifications -- many of which will end in re-default -- at least they can take those losses over a longer period of time. So without the brute force of government coercion, I find it unlikely that the principal reduction possibility will be considered much by banks.

Speaking of that re-default potential, I had one other interesting observation from Seth Wheeler's testimony. He indicated that unemployment benefits can count as income in the underwriting process for the HAMP program modifications. I wasn't aware of that, and find it a bizarre feature of the program. These unemployment payments are temporary, and there's no telling how long it can take for these borrowers to find new employment. And even when they do, it's unclear whether their new job's pay will fall short of their modified payment requirements. This doesn't bode well for the permanent modifications through HAMP actually performing well for the life of the loan.