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July 29th, 2009

Foreclosures and banks’ best interests

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This Washington Post article, which highlights a key element of why the government-sponsored loan mod programs aren’t as successful as they could be, has received a lot of attention. However, it doesn’t tell the whole story:

Policymakers often say it’s a good deal for lenders to cut borrowers a break on mortgage payments to keep them in their homes. But, according to researchers and industry experts, foreclosing can be more profitable.

The problem is that modifying mortgages is profitable to banks for only one set of distressed borrowers, while lenders are actually dealing with three very different types. Modification makes economic sense for a bank or other lender only if the borrower can’t sustain payments without it yet will be able to keep up with new, more modest terms.

A second set are those who are likely to fall behind on their payments again even after receiving a modified loan and are likely to lose their homes one way or another. Lenders don’t want to help these borrowers because waiting to foreclose can be costly.

Finally, there are those delinquent borrowers who can somehow, even at great sacrifice, catch up without a modification. Lenders have little financial incentive to help them.

Few would, I believe, argue that those in the second set, who would probably lose their homes “one way or another,” should be eligible for a loan mod; the government’s own statistics show that more than 50% of loans modified in the first quarter of 2008 re-defaulted within six months. A loan mod in such cases would, more than likely, merely delay the inevitable — and compound the lender’s costs to boot. To its credit, the WaPo article notes as much.

However, there’s a key aspect to the loan-mod plan that few have picked up on. It’s not only about whether a foreclosure is “more profitable” to a bank than a loan mod, though that certainly matters (especially now). What the Post article doesn’t mention is that under the Making Homes Affordable plan, loan mods should be made with as little cost to the government — which means we taxpayers — as possible (PDF):

Protecting Taxpayers: To protect taxpayers, the Homeowner Stability Initiative will focus on sound modifications. If the total expected cost of a modification for a lender taking into account the government payments is expected to be higher than the direct costs of putting the homeowner through foreclosure, that borrower will not be eligible.

Lenders participating in the MHA loan-mod program are required to use a cost-benefit analysis to determine whether a given borrower is eligible for a taxpayer-funded loan modification. While it might be nice to modify everyone’s loan, as noted above, that’s just not cost-effective — and might even be a little cruel in holding out false hope to some homeowners.

UPDATE: Our in-house expert, Keith T. Gumbinger, points out that it’s incorrect for the WaPo to characterize lenders as “profiting” from this situation. No one wins in a foreclosure, certainly not the lender, and a loan mod isn’t all that much better. Given that the lender and downstream investors expected to make a reasonable return when the loan was originated at, say 6%, and given that the loan mod will reduce that rate to around 2%, it would be more accurate to say that the loan mod will result in less of a loss to the lender/investors.

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About the HSH Blog

HSH.com's daily blog focuses on the latest developments in the mortgage and housing markets. Our mission is to relate how changes in mortgage rates and housing policy, as well as the latest financial news, impacts consumers, homebuyers and industry insiders alike. Our 30-plus years of experience in the mortgage industry gives us an edge as we break down the latest changes in an ever-changing market.

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Tim Manni

Tim Manni is the Managing Editor of HSH.com and the author of their daily blog, which concentrates on the latest developments in the mortgage and housing markets.

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