Loan modification entitlement curtailed as prices rise
Lenders tighten the terms of loan modifications as prices near the peak and lenders have less risk of loss in foreclosure.
When a borrower secures a loan to purchase a house, they negotiate with lenders over the cost of borrowing (interest rate). In the wake of the new mortgage regulations, loan terms are generally uniform among lenders, and the cornerstone of residential real estate lending is the mortgage agreement, the document that the borrower signs that pledges the house as collateral if they stop making payments according to the Promissory Note.
Ostensibly, when the promissory note was signed, loanowners and lenders agreed to the price of money (interest rate and payment) and terms. Unfortunately, during the housing bubble, the terms of Promissory Notes were onerous, and many borrowers faced excessive and escalating monthly housing costs while simultaneously facing declining house prices and the elimination of their equity. This prompted many borrowers to strategically default, and lenders worried that more would follow.
If borrowers default while the collateral is worth less than the outstanding balance on the Promissory Note, the lender is in a difficult situation. If they foreclose, they will not be able to resell the collateral for enough to recover their capital, and if a large number of borrowers default, the resulting foreclosures depress resale values and causes lenders to lose even more, perhaps even leading to lender bankruptcy.
The reasonable solution is for lenders to avoid foreclosure to prevent the downward spiral of declining home values leading to more defaults and even greater losses; however, if lenders refuse to foreclose, then borrowers strategically default for a different reason: they know they can get free housing. Borrowers become delinquent mortgage squatters.
The solution lenders finally came up with was to offer borrowers terms of repayment that enticed them to pay something rather than simply squat and pay nothing. Remember though, lenders don’t want to make loan modifications. If the borrowers had equity, they would simply foreclose on them and get their money back. Since so many are so far underwater, the banks can’t foreclose on them and get all of their money back, so it’s in their best interest to cut deals, amend loan terms, kick the can, and pray these borrowers will make payments until prices come back.
As prices near the peak, circumstances change back in favor of the banks, and their motivation to be accommodating and make loan modifications vanishes. Many people view loan modifications as a new housing entitlement: It’s not. The moment borrowers are no longer underwater, the lenders rescind the entitlement because they would rather foreclose and get their money back, money they can loan to someone who will make payments based on the original contract terms.
Ruth Mantell, June 22, 2015
WASHINGTON (MarketWatch) — There’s been a dramatic change in the assistance offered to struggling homeowners.
In February, 49% of borrowers with a loan backed by federally controlled housing-finance giants Fannie Mae and Freddie Mac received modifications that only extended the length of their mortgage. That share was up 20 percentage points from a year earlier, according to a report from the Federal Housing Finance Agency, which regulates the government sponsored enterprises. Over that same time period, the share of borrowers receiving a modification that combined an extended term with other actions, such as a rate reduction and principal forbearance, fell by 19 percentage points.
This should come as no surprise to regular readers here. Back in 2011 I noted that Loan modifications are not an entitlement, banks don’t want to make them one. Then in 2013 I predicted the Loan modification entitlement will be rescinded as prices near the peak, evidence of this above.
The next phase of the process is outlined in a post from 2014, The final resolution of loan modifications will push people out of their homes. The result will be Mortgage and foreclosure crisis 2.0. We will see more on those developments later as they occur. My analysis is intended to provide a view of things to come.
Similar trends are seen in quarterly data from the Office of the Comptroller of the Currency, which publishes a snapshot of the U.S. mortgage market. According to the OCC, the chance that a modification included a term extension rose by 10% in 2014. Meanwhile, the likelihood dropped 15% for a rate reduction and 66% for a principal deferral.
The reason? The big rise in home prices since 2012.
“As the market improves, the number of borrowers who are in deep distress goes down, so the average modification tends to get lighter because they don’t need to provide as much relief,” said Jim Parrott, a former housing-policy adviser for the White House’s National Economic Council and a senior fellow at the Urban Institute, a Washington think tank.
It has nothing to do with how much relief borrowers require: the change in terms on loan modifications has everything to do with lender exposure. As prices near the peak, lenders have less risk of loss, and once the collateral value is worth more than the loan, they have no motivation at all to modify terms.
“The practice of providing a modification to somebody with significant equity is fairly new,” said Julia Gordon, senior director for housing and consumer finance at the Center for American Progress, a left-leaning think tank in Washington. “The assumption in the past, pre-crisis, was if you get into terrible trouble with your mortgage, your solution was to downsize.”Borrowers with enough equity can sell their home without taking a loss. For those who aren’t underwater, yet struggling with monthly payments, Gordon questioned whether they should take a modified loan.
“When a borrower who has equity is seeking a modification, I think it is much more important for that borrower to get really good advice about whether staying in the home makes sense or whether moving might make sense,” Gordon said.
There is no practice of modifying a loan when a borrower has equity. Why would a bank do this?
What the statements above really point to is the situation I described in The final resolution of loan modifications will push people out of their homes. Lenders are in the business of loaning money and maximizing the return on their capital; they aren’t a charity providing lifelong subsidies to borrowers who want to remain in houses they can’t afford. Borrowers need to prepare for their exit because petitioning for continued subsidies will fall on deaf ears.
It’s almost an understatement to describe the U.S. housing market’s recovery as “uneven.” There are still pools of deeply troubled borrowers in hard-hit markets, weighed down by weak local economies and a large overhang of distressed properties, even as homes elsewhere sell at record highs. Just five states — Nevada, Florida, Illinois, Arizona and Rhode Island — account for almost one-third of negative equity in the U.S., according to CoreLogic. …
The negative equity situation in Nevada and Florida is the main reason these two states remain good candidates for cashflow property investment. Lender can-kicking is going to keep supply off the MLS for a very long time in these states because prices have a long way to go up before the deeply underwater borrowers can sell without a loss.
Servicers use principal reduction to modify loans held in their own portfolios and those serviced for private investors, according to the OCC. However, Fannie and Freddie don’t allow principal reduction, a position so irksome to some that a campaign was launched calling for President Obama to fire Ed DeMarco, the former head of the GSE regulator.
DeMarco eventually left FHFA, to be replaced by Mel Watt, a former representative for North Carolina. While in Congress, Watt had supported legislation that would allow certain principal forgiveness. But since he’s been at FHFA, the regulator hasn’t announced any far-reaching programs to allow principal reduction for troubled loans, disappointing some of his one-time supporters.
However, the FHFA is considering a targeted plan for forgiveness, and is getting closer to a public announcement, according to people familiar with the regulator’s plans. Earlier this year, Watt told U.S. lawmakers that the FHFA was studying the issue of allowing principal reductions.
“What we’re trying to do on principal reduction is find a place where it is beneficial to borrowers and…not negative to Fannie and Freddie,” Watt said. “And when we find that, that niche, that’s when we’re going to make a decision about this.”
The decision has already been made, but Watt can’t publicly give the bad news because the hope of principal reduction is the only thing making many deeply underwater borrowers hold on. The dangling carrot they will never obtain buys time while prices recover.
Personally, I think Mel Watt’s decision not to forgive principal was the right one. Besides encouraging moral hazard, widespread principal forgiveness either would cost the US taxpayer trillions of dollars (that’s trillions not billions), or it would have wiped out many investors in GSE loans, many of which are held by large pension funds that would trigger another massive bailout. I give him credit for not screwing things up at the FHFA.
The time when principal reductions were possible is long since past. The time when loan modifications became the norm is waning, and in a few years, this pseudo-entitlement will be rescinded completely, and lenders will finally embark on the final resolution of loan modifications that will push people out of their homes. It’s all playing out in a predictable pattern.