Foreclosure relief has been the great white whale of this recession, valued but hard to find. Most everyone agrees that ending foreclosures and stabilizing the housing market would help improve the economy in a variety of ways, but no one has found a good way to go about halting foreclosures since that action is expensive and someone has to accept a loss on loans made for homes that have plunged in value. People facing foreclosure can't afford to pay their mortgages, lenders don't want to refinance, potentially losing profits, and it isn't politically feasible for the government to step in and take the loss. And so we're left with a voluntary program where certain borrowers facing foreclosure can get new government insured mortgages as long as their lenders will take a loss on the original loan, and predictably enough very few people are taking advantage of this program.
One smart idea to solve the problem comes from Senator Dick Durbin, who points out that when someone is facing bankruptcy, the judge supervising their case can modify the structuring of any of their debt except for primary residential loans. Durbin would like to remove that restriction so that people facing bankruptcy can have their home loans restructured, which would prevent banks from pursuing expensive foreclosure procedures and losing a revenue stream while keeping homeowners where they belong -- in their homes, paying of their debt on a more reasonable schedule. Everybody wins, right? But lenders complain that this will still result in big losses on their part.
It turns out, however, that when you actually look at the numbers, it's just not true. Adam Levitin is an Associate Professor at Georgetown University Law Center, and his research indicates that mortgage modification actually results in a much lower rate of loss for lenders than foreclosure. When a bank foreclosures, they lose on average 55 percent of their loan principal. In a restructuring, even in the areas with the biggest drops in home value, they lose only 23 percent on average. He notes as well that this provision would not result in large changes to mortgage interest rates.
Levitin also offers the change as a solution for the problem of securitization, which has left many mortgages cut into numerous tranches owned by different entities. This practice can result in 40 parties becoming involved in restructuring a loan, making agreement difficult if not impossible. Levitin argues that bankruptcy judges who can force restructuring provide the only feasible mechanism for modifying loans.
Finally, Levitin has a theory, from this testimony, about why the voluntary mortgage modification program hasn't worked and why the Mortgage Bankers Association opposes this change:
If we want to understand why we are seeing such dismal voluntary efforts at loan modification, we have to take the advice of Deep Throat and follow the money.
That trail leads to mortgage servicers, like many of the members of the Mortgage Bankers Association.
Servicers are supposed to manage securitized loans in the interest of mortgage-backed-security-holders.
Yet servicers' compensation creates an incentive for servicers to foreclose even if modification is in the interest of investors.
When servicers modify a loan, they receive fixed-rate compensation. But in foreclosure, the servicer is compensated off the top of foreclosure sale proceeds on a cost-plus basis. There is no one monitoring the cost, and there is no one monitoring the plus.
This compensation structure creates a powerful economic incentive for servicers to foreclose regardless of the impact on investors, on homeowners, and on communities.
Bankruptcy modification would shut down this gravy train and remove the economic incentive for servicers to foreclose. Bankruptcy modification would hurt servicers' bottom line, and that is why service trade organizations like the Mortgage Bankers Association have been fighting so hard against it, even as mortgage-backed- security-holders have been largely silent.
So it turns out a middle-man business interest with a powerful lobby is fighting against common-sense legislation that would benefit both actual lenders and borrowers, as well as the economy as a whole. Surprised?
-- Tim Fernholz