Short Sale, Foreclosure and Strategic Default

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Wednesday, January 21, 2009

Why traditional Loan Modification is difficult

One of the best articles I have seen on the subjectof loan modification.  Perhaps the reason why you need to gain legal leverage over the servicer and lender before you begin a loan mod. 



National Mortgage News - MortgageWire Archive
Trouble with Loan Mods Trouble with Mods

By Kate Berry, American Banker

As the mortgage industry begins modifying troubled loans in greater numbers, early rounds of modifications are coming in for bad performance reviews for failing to prevent borrowers from defaulting again.

A handful of analysts and academics who have studied which types of loan modifications work have found that some of the most common changes - reducing or freezing the interest rate and allowing missed payments to be rolled into the balance - often fail to prevent re-defaults.

These are, of course, high-risk loans by definition. But one aspect of some modifications points to why the default issue can re-arise so quickly. The addition of arrears and fees to loan balances can actually increase monthly payments, a situation that leaves strapped borrowers no better off from a monthly cash-flow perspective. (Not all lenders charge fees on modifications. Bank of America Corp., for example, waives fees on the Countrywide Financial Corp. loans it is modifying under an agreement with state attorneys general.) Also, in an environment where house prices are falling, higher loan balances can erode or wipe out a homeowner's equity.

"We're going backwards," said Alan White, an assistant professor at Valparaiso University School of Law. "The voluntary modifications are putting people underwater more than they already are and those terms are contributing to the failure rate."

Mr. White said he examined the September and October remittance reports on $4 billion of bonds backed by subprime and alternative-A mortgages. Of the loans that were modified, roughly 72% received some form of "negative prepayment" that increased the principal balance.

He and others said that the most effective modifications are the ones that reduce principal as well as the interest rate. But principal reduction remains rare.

Rod Dubitsky, the head of Credit Suisse Group's asset-backed securities research, division found that only two servicers - Ocwen Financial Corp. and Goldman Sachs Group Inc.'s Litton Loan Servicing LP - are doing it in any great numbers. "It seems that the momentum in mods is taking principal forgiveness off the table," Mr. Dubitsky said.

Servicers are less likely to make loan modifications that result in lower payments than those that result in higher payments, he said.

In his own analysis of monthly trustee reports from 19 servicers, Mr. Dubitsky found that about 30% of borrowers who received any type of modification in the fourth quarter of last year became 60 or more days delinquent within eight months.

Of the loans that received "traditional" modifications (rate reductions or capitalizations of past-due payments) resulting in higher payments, 44% defaulted within that time frame, he said. By comparison, the rate for principal reductions was 23%. Another group of modified loans - hybrid adjustable-rate mortgages whose rates were frozen or did not rise as much as originally planned - performed slightly better, but Mr. Dubitsky said most of those had not defaulted before modification.

Some servicers acknowledge that principal reduction would be a more effective way to prevent foreclosures, but they say their hands are tied.

"The guys in the trenches will tell you that if you don't offer some level of principal forgiveness to the borrower who is upside-down on their loan, you will have a high failure rate," said Tom Marano, the chairman and chief executive of Residential Capital LLC. But "there are a lot of cases where the investor does not allow us to reduce the principal."

His Minneapolis lender, a unit of GMAC LLC, typically offers an interest rate reduction first. If the borrower still has trouble keeping up, ResCap will then recapitalize missed payments.

Mr. Marano suggested that one way to help underwater borrowers was to offer a deal in which investors would get a share of any future appreciation of the home in return for lowering monthly payments. "We need to offer the borrower something to keep them incented but not give them a free pass," he said. But ResCap has not tried this because investors will not let it do so, he said.

Negative equity is a major factor in determining whether a delinquency leads to a foreclosure, but historically it has not been found to prompt delinquency in the first place.

Mark Fleming, the chief economist at First American CoreLogic Inc., said that for owner-occupied homes, "under moderate levels of being underwater, most individuals would choose to stay put." He pointed to factors like the enjoyment and shelter people get from their homes, ties to the community, and the costs of moving.

But with the depth of home price declines, the question now is "how far underwater does a homeowner need to be to decide to walk away?" Mr. Fleming said.

Over the last year, he said, one of the largest drivers of foreclosures has been negative equity, which makes it impossible for people to sell their houses to pay off loans once they get into trouble after the loss of a job or a divorce, or any of the customary causes of delinquency.

In his study, Mr. White found that servicers forgave an average of $1,914 in unpaid interest and fees on modified loans. But they increased principal by an average $11,200, including interest on arrears, taxes and insurance advances. Servicers will foreclose on a homeowner for a loss of roughly $121,000 a loan rather than forgive "a few hundred dollars" of debt, he said.

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