It’s tough to modify your way out of a hole
If you thought the U.S. housing crash could be blunted if only lenders would cut delinquent borrowers a break, it is perhaps time to move on to another vain hope.
That’s right, the loan modification movement – pushed by the U.S. administration and others as a means of keeping non-paying borrowers in their houses, keeping those same houses from flooding the market as foreclosures, and even helping beleaguered lenders – is running into a reality-shaped wall.
An exhaustive study of loan modifications by economists at the Boston Federal Reserve, under which delinquent borrowers are given lower rates, more time, or even cuts in the principal amount owed, showed fundamental problems with the way that idea works when put into practice.
Looking at data that covers about 60 percent of U.S. mortgages the authors, Manuel Adelino, Kristopher Gerardi, and Paul S. Willen, came up with two important conclusions.
First, securitization, whatever its other shortcomings, is not an important factor in stopping loan servicers from cutting deals with delinquent borrowers.
Second, and even more importantly, lenders don’t renegotiate for a simple, unanswerable reason: it is not in their best interest financially.
Virtually every rescue plan in the U.S. since the crisis began in 2007 has been in part a loan modification program, the most recent being the Making Home Affordable plan the Obama administration unveiled in February.
The thinking is that, as a foreclosure can cost the lender between 30 and 50 percent of the value of the loan, deals can be struck with borrowers for a lot less than that leave everyone better off.
Sadly, very few loans are being modified – only about 3.0 percent of delinquent loans – with many blaming securitization, which can make a loan modification toxic for one class of lender but beneficial for another.
Seeing as how securitization was part of the way finance spun of control and the bubble was inflated, this was a satisfying narrative, but a false one according to the Fed study. They found no significant differences in the rate of renegotiation among loans that were in private-label securitizations and those actually owned by the servicer doing the negotiating with the borrowers.
NEITHER A BORROWER NOR A MODIFIER…
The real issue is that, in the vast majority of instances, banks are better off not modifying.
For one thing, about 30 percent of borrowers who become delinquent get back on track before foreclosure. Since its very hard to know which borrowers will become payers again, this implies that 30 percent of the money expended in modifying loans is wasted, at least from the lenders point of view.
Secondly, a huge percentage of borrowers who are given new improved terms go and become delinquent all over again. A whopping 40 to 50 percent of borrowers who get modified loans are 60 days delinquent again six months later.
For them, and for their banks, it is just delaying the inevitable, and expensive to boot, as falling property prices make putting off foreclosing and liquidating costly.
The implication is that unless the government wants to pony up much larger amounts of money to entice lenders to modify loans, we are not going to make much of a dent in the wave of foreclosures washing across the economy. This could be done, and possibly support house prices in the process, but at a very high costs.
The real issue is that there are too many houses for the supply of credit worthy borrowers. The re-default rate shows that, as does the low clearing price when banks sell foreclosed houses.
Housing needs to fall in value, less of it needs to be built, and more people should become renters. That is going to continue to eat away at bank capital and act as a drag on growth.
Beyond that, there is a real question about the long-term consequences of mass loan modification. If the incentives are there more borrowers will become selectively delinquent and fewer who become delinquent will in the end catch up with their payments. Why should they?
That means higher loan rates than would otherwise be the case.
The thinking behind loan modification has interesting parallels in the rest of the economy, where policy makers are following similar strategies for banks and corporate borrowers.
Rather than simply cutting back on leverage, probably via default, there seems to be a consensus for stringing struggling borrowers, and lenders, along, hoping that something turns up.
Ultimately, it seems likely that strategy is about as successful in the rest of the economy as it seems to be in housing.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)