Two enter the Octagon — only one can emerge victorious.
This week, both the Washington Post and the New York Times have published reports purporting to explain why so few mortgage-loan modifications are taking place despite an Obama administration program that provides incentives for banks to modify loans. Both reports cite a recent study from the Boston Fed to back up their hypotheses, but they draw different conclusions. Who is right?
On Tuesday, the Post reported that mortgage lenders are not modifying loans because “modifying mortgages is profitable to banks for only one set of distressed borrowers, while lenders are actually dealing with three very different types.” First, there are borrowers who fall behind on their payments but who will eventually start making them again, i.e. those who “self-cure.” Second, there are borrowers who simply bought more house than they could afford and are likely candidates to redefault. Third, there are borrowers who could catch up, but only if they received a loan modification. Modifications only make sense for the third group.
This, more or less, is what the researchers at the Boston Fed concluded:
… what is the explanation for why lenders do not renegotiate with delinquent borrowers more often? We argue for a very mundane explanation: lenders expect to recover more from foreclosure than from a modified loan. This may seem surprising, given the large losses lenders typically incur in foreclosure, which include both the difference between the value of the loan and the collateral, and the substantial legal expenses associated with the conveyance. The problem is that renegotiation exposes lenders to two types of risks that can dramatically increase its cost. The first is what we will call “self-cure” risk. As we mentioned above, more than 30 percent of seriously delinquent borrowers “cure” without receiving a modification; if taken at face value, this means that, in expectation, 30 percent of the money spent on a given modification is wasted. The second cost comes from borrowers who redefault; our results show that a large fraction of borrowers who receive modifications end up back in serious delinquency within six months. For them, the lender has simply postponed foreclosure; in a world with rapidly falling house prices, the lender will now recover even less in foreclosure. In addition, a borrower who faces a high likelihood of eventually losing the home will do little or nothing to maintain the house or may even contribute to its deterioration, again reducing the expected recovery by the lender.
Today, the New York Times offers a different theory: Banks are not offering modifications because the foreclosure process provides opportunities for servicers to extract lucrative fees. In support of this theory, the reporter, Peter Goodman, quotes a passage from the Fed study:
“The rules by which servicers are reimbursed for expenses may provide a perverse incentive to foreclose rather than modify,” concluded a recent paper published by the Federal Reserve Bank of Boston.
In context, though, this passage takes on a different meaning. The Fed study’s authors were listing a number of factors having to do with securitization that, in their analysis, do not contribute significantly to the dearth of modifications:
More precise institutional evidence appears to confirm the role of securitization in impeding renegotiation. As mentioned in more detail below, PSAs do sometimes place global limits on the number of modifications a servicer can perform for a particular pool of mortgages. In addition, the rules by which servicers are reimbursed for expenses may provide a perverse incentive to foreclose rather than modify. Furthermore, because servicers do not internalize the losses on a securitized loan, they may not behave optimally. Another issue is the possibility that those investors whose claims are adversely affected by modification will take legal action. Finally, historically, SEC rules have stated that contacting a borrower who is fewer than 60-days delinquent constitutes an ongoing relationship with the borrower and jeopardizes the off-balance sheet status of the loan.
But some market observers express doubts about the renegotiation-limiting role of securitization. […] Our empirical analysis provides strong evidence against the role of securitization in preventing renegotiation.
It seems pretty clear to me that, whatever other evidence the Times may have for its theory, the Fed study doesn’t count. Inconveniently for the administration and its, ahem, supporters, the study’s authors dismiss the idea that vampiric fee-extraction plays a significant role in the foreclosure process. Instead, they conclude that banks are making decisions based on each borrower’s ability to repay. Considering that it was a complete deterioration of lending standards that blew up the housing market, shouldn’t that be a welcome change?