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.

The redefault rate assumption is key for principal reductions. Many housing experts agree that when mortgages remain underwater even after modification, borrowers have a much higher rate of redefault. So if banks cut principal to match the value of a home, then equity can begin being built much sooner, which will provide borrowers greater incentive to keep paying. Redefault rates should, thus, be much lower for principal reductions. This could be a very significant change that would push more modifications involving principal reduction.

Reforming the Bankruptcy Process

The state AGs and other federal enforcement agencies are also pushing for the reduction of mortgage debt in the bankruptcy process.

"Servicer shall consider implementation of a special loan modification process for bankruptcy cases where the borrower (a) is considered for voluntary principal reduction to fair market value of property while other unsecured debt is discharged; or (b) as part of a Chapter 13 plan, the interest on the borrower's first lien is reduced to zero for five years and then reamortized at a market rate for 25 years at the conclusion of the five year payment plan," the term sheet says.

These changes would be subtle, but they would also have an impact. In particular, they would push servicers to modify mortgages in cases of bankruptcy. The enforcement mechanism here would likely fall on the shoulders of bankruptcy judges. Unlike a once-popular strategy of giving those judges more leeway to "cram-down" and re-write mortgages to make them more affordable to borrowers, they would enforce this settlement requiring servicers to consider a modification as part of the process.

This settlement provides quite a few sticks to push servicers to modify more mortgages. For that reason, it may be more effective than the Treasury's attempts to encourage servicers to modify by providing tiny carrots instead. In the settlement, investors, the Consumer Financial Protection Bureau, and bankruptcy judges might all have a chance to order servicers to modify mortgages instead of foreclosing. If these settlement provisions are accepted, and they work as intended, then modifications would likely increase. We might also see a big increase in principal reductions.