Designed to Fail

Two years into its life, the Obama administration's headline housing effort, the Home Affordable Modification Program, or HAMP, is struggling, and so are the families it's supposed to help. Well over a million homes have been lost to foreclosure since the HAMP program began, and more than 4 million additional homes are either in the foreclosure pipeline or likely to default over the next few years. But more than 60 percent of seriously delinquent homeowners are never even contacted to discuss help with their mortgage. Even families who manage to keep their home are often burdened by crushing levels of mortgage debt inherited from the housing bubble. More than one in every 10 American mortgage holders has a loan at least 20 percent greater than the value of their home.

Yet HAMP has resulted in only about 540,000 permanent modifications to reduce homeowner mortgage payments. These modifications do significantly lower monthly payments (by an average of $527), but the number is modest compared to the magnitude of the problem and falls far short of the 3 million to 4 million modifications promised by the administration when the program began. The pace of new monthly modifications has also dropped by half in the past year, indicating that the bulk of the program's impact may be behind it.

If the numbers look mediocre, the reality for homeowners is often even worse. Almost from the beginning of the program, journalists have been telling stories of families struggling with baroque and incomprehensible HAMP bureaucracy. Qualified homeowners often have to fight for more than a year to obtain a modification. Bruce Dorpalen, public affairs director for Affordable Housing Centers of America, describes HAMP-eligible families "in limbo" for six, 12, or even 18 months and possibly going into foreclosure during that time. "It's very common for our housing counselors to be working with a family the day before a foreclosure sale in order to stop it. ... The sale will then be postponed a month and the process has to be repeated."

A homeowner's journey through HAMP usually starts with reaching out to the servicer -- the private company that collects mortgage checks, typically a specialized subsidiary of a large bank. Usually the mortgage servicer does not own the loan but passes payments on to the investors who are the actual owner. The servicer then handles the entire HAMP process, from verifying borrower income to determining eligibility to offering the modification. In practice, almost every step in this process has been at best confusing and at worst maddening for borrowers.

Servicers reject more than a fifth of borrower applications for paperwork reasons -- often due to lost paperwork by the servicer itself. An October, 2010 ProPublica survey found that homeowners seeking modifications had to send the same documents an average of six times before they were received. If the paperwork hurdle is passed, servicer bureaucracy results in substantial delays in determining eligibility. Servicers often reject modifications if they decide the borrower isn't in enough financial trouble. When they do grant modifications, they rarely reduce the total debt burden of the consumer. Instead, modifications generally cut interest rates temporarily and reschedule payments.

While borrowers wait for the servicer to determine eligibility, the foreclosure divisions of the same servicer often continue the foreclosure process, sometimes leading to borrowers getting foreclosure notices from the same servicers with whom they are negotiating a modification. Although servicers are technically required to follow extensive government guidelines, the federal government does not levy fines or penalties for violations.

It wasn't necessary to essentially hand the HAMP program over to loan servicers. Thanks to government -- sponsored housing programs, the federal government has enormous resources and expertise in housing. Nor did the servicers have information unavailable to government. There are large national databases available that include data on almost all mortgage loans.

The government also could have legally mandated modifications. HAMP requires restructuring loans only if the modification is economically rational -- that is, if the expected cash flow from modifying the loan exceeds the expected cash flow from leaving the loan as is and running an increased risk of foreclosure. In early 2009 when the program began, the big banks that own most major servicers were utterly dependent on taxpayer subsidies, leaving them in a poor position to contest mandates.

Indeed, a program that inspired HAMP shows how government could have sidestepped servicer issues to directly assist homeowners. When the Federal Deposit Insurance Corporation (FDIC) took over the failed IndyMac bank in 2007, it inherited a large portfolio of troubled loans. The FDIC simply analyzed the entire loan portfolio to see if a loan modification would save money compared to leaving the loan unmodified and risking foreclosure. If a modification appeared economically rational, the FDIC approached the borrower and directly offered the modification. If the borrower accepted, the modification was done. While this program wasn't perfect, it ran comparatively smoothly and avoided the massive paperwork problems experienced in HAMP.

Why didn't HAMP follow the IndyMac model? IndyMac had already failed, and the FDIC temporarily owned it. But in the case of other large banks, the administration desperately wished to avoid bank takeovers. HAMP was also shaped by the desire of the administration, particularly the Treasury Department, to not disrupt the operations of the big banks it had recently rescued.

Another critical choice made early on was that HAMP would not mandate that banks actually reduce the total mortgage debt held by homeowners. Instead, only temporary reductions in interest rates were made. This choice meant that HAMP would put much less pressure on both bank balance sheets and government budgets. But it also meant that it would provide only limited assistance to the millions of homeowners struggling with a mortgage that was enormously greater than the current value of their home.

By choosing to rely so heavily on mortgage servicers, the government was putting its housing strategy in the hands of a basically unregulated industry, one that had undergone a significant transformation that made it in many ways unsuited to the task. A generation ago, when many mortgage loans were originated and held by local banks, the originating bank often collected the mortgage checks and serviced the loan. This created a close, service-oriented relationship with the homeowner, who was often a depositor at the bank and a customer for other banking services.

Since around 1990, as securitization came to dominate the market, mortgage servicing has become a commodity business dominated by a few large players, who use economies of scale and information technology to provide standardized and mostly automated bill collecting and servicing. In 1989, the 10 largest mortgage servicers serviced just 11 percent of American mortgages. Today, the four largest -- dominated by big banks such as Bank of America, Wells Fargo, and Citibank -- service more than 70 percent of mortgages.

With millions of mortgages to manage, most of which are owned by faraway investors and not by the servicing banks themselves, servicers became bureaucratic and routinized and lost much of their flexibility in dealing with the situations of individual borrowers. Their business model relied on high-volume, low-cost standard procedures, not the "high touch" interactions sometimes necessary to help a borrower struggling with an unsustainable mortgage.

During the housing-bubble period, with home values increasing steadily, there was little need to renegotiate loans. If borrowers couldn't pay their mortgage, it was generally possible for them to sell the house. And in the rare case of a foreclosure, the investor could easily recover the loan principal. But as delinquency and foreclosure rates skyrocketed, and equity went negative during the housing collapse, servicers found themselves without the staff, resources, or organization to handle the problem.

Not only do servicers lack capacity; it's far from clear they had the right incentives to perform even economically rational mortgage modifications. Most loans aren't owned by the banks that service them. Ownership of securitized loans is divided among dozens or hundreds of investors in mortgage-backed securities, and the mortgage servicer simply receives fees to manage the loan. So even if investors have an interest in avoiding a foreclosure, that's not necessarily true for the servicer.

Servicer incentives depend on the balance between the servicing fees collected in the event of a delinquency or foreclosure and the fees collected for a modified loan that continues to perform. In many circumstances, servicing fees can be higher for a nonperforming loan followed by a foreclosure than for a loan restored to performing status through a modification. In the event of foreclosure, the servicer is often first in line to recover any fees and advances owed to them, while investors must take a loss. The HAMP program tried to counteract these negative incentives through bonus payments to servicers for completed modifications. But these bonuses haven't been sufficient to counteract the twin forces of servicer incapacity to deal with borrowers and lack of incentives to perform socially beneficial modifications.

If the bonus "carrot" wasn't sufficient to induce better servicer performance, a more effective "stick" might have done so. But even though most of the largest servicers were owned by major banks receiving TARP payments, the government failed to use this leverage. It also failed to press for an alternative route to mortgage modifications. Residential mortgages are one of the few types of debt that cannot be modified in bankruptcy. Early in the housing crisis, advocates championed a proposal to permit bankruptcy-court judges to modify mortgages. This would have provided an alternative way to relieve mortgage debt and created real pressure on servicers to provide modifications to avoid bankruptcy for homeowners. At various points -- during the TARP negotiations and the stimulus debate -- this proposal appeared to have sufficient congressional support to pass. But first Senator and then President Barack Obama failed to vigorously support the idea, and it lost due to financial sector opposition.

The decline of housing values from artificially inflated levels left homeowners who purchased during the housing bubble trapped with enormous debt burdens. The inflation of housing values was driven by a broader failure of the financial system; homeowners in many markets had no choice but to buy at inflated prices if they wanted to own a home. A fair division of the fallout from this societal failure would have split the costs between financial institutions and affected homeowners and society as a whole. Such a division would also have been a more effective way of addressing the recession, as outsized debt burdens left over from the housing bubble have been a significant factor holding back broader economic recovery.

But the burden of housing debt has not been shared fairly. Buoyed by a range of recovery programs, banks today are showing record profits and cash reserves. Meanwhile, the burden on consumers from negative housing equity has barely declined over the past two years. Unfortunately, the attitude that created the shortcomings of the HAMP program is still alive and well. The consent decree recently proposed by federal banking regulators to address evidence of widespread servicer fraud and abuse continues to give enormous discretion to servicers in controlling the modification process, and it doesn't require real remedies for home-owners. The regulator proposal may undermine the drive for tougher penalties and stricter servicer requirements by the Justice Department and state attorneys general pursuing a criminal case.

Indeed, despite all its flaws, many Washington insiders continue to view HAMP as a qualified success, a program that has helped several hundred thousand homeowners reduce mortgage payments at a low cost to both government and the banks. Until we get serious about requiring banks and servicers to assist deserving borrowers on a scale commensurate with the foreclosure crisis, we'll continue to reproduce the timid incrementalism shown by HAMP.