Why so few loan mods?

The HASP effort from the Treasury/White House/HUD has been in play for over a month now. By some measures, lenders are beginning to use the program and at the least there are refinances being made through Fannie and Freddie for loans with loan to value ratios of 80-105% of appraised values ("shallow under water" loans).

In the last week we heard that FHA loans are performing poorly. This created headlines about an FHA 'bailout'...which is not quite right. FHA charges a premium and has generally added to the Federal revenues every year due to a surplus of premiums paid over payouts (there is no "lock box" for Federal programs). In many ways this has been a tax on homebuyers which returned billions to the Treasury. Due to a slew of loans in 2005-2007 where downpayments were gifted by sellers (a blueprint for disaster to all who watched it happen), FHA has a book of loans that is doing lousy. That program has ended and FHA volume overall is robust. FHA may need, for the first time in history, a subsidy for its premiums. Or it could simply to raise its current premiums. But this is not quite a collapse of an otherwise pretty good program.

But the news on loan mods is more modest. Still lenders are slow to get mods approved and seem to still end up doing more foreclosures than alternatives. New data will soon be out from HOPE NOW and some state programs to see if or how fast things are changing.

A recent paper by Christopher Foote, Kristopher Gerardi, Lorenz Goette and Paul Willen on the Boston Fed website (Public Policy Discussion Paper P09-2) with the pithy title "REDUCING FORECLOSURES" has some interesting implications.

The authors argue that loans originated with high mortgage payments relative to income, or at so at "unaffordable levels," are not the main reason that borrowers default. They suggest it is actually household income shocks such as a job loss or income reduction, combined with a declining house price market.

Because investors usually gain more from foreclosures than modifications, the system is set up to pursue foreclosure options even if the borrower may be able to maintain a modified loan. They argue that PSA and securitization agreements are not the barrier to servicers often suggested, and that investors are not putting legal pressure against mods as much as simply are economically better off foreclosing. It would be better for society, borrowers, neighborhoods, etc for more mods to be made, but probably not for specific investors facing a trade off between forms of losses. Both a mod and foreclosure mean a loss. Mods may just prolong the problem in too many cases.

The authors conclude that mods may need to be re-directed. Rather than reducing payments below 31% of income for 5 years across the board, as in the HASP, a better approach would be to focus on the trigger event to get the borrower through until a better income level is achievable, then revert to the prior terms.

It is a nicely written paper and engages a useful discussion of what we ought to consider affordable or "sustainable" lending. It should be noted they do not find income to mortgage payment ratios are not unimportant, just that income:payment at the time the loans is made is not a main driver of default. From other data we know mods that reduce payments tend to perform better over time. In fact the authors repeat this finding. But the situation each borrower is in varies, as does the availability of data on changes in income over time.

One proposal put forth by Steve Malpezzi and colleagues at the Center for Real Estate at the University of Wisconsin Business School is that unemployment benefits could include a temporary housing voucher which pays any amount over 30% of income for making housing payments. The result is a bit like a short term insurance contract against default.

It seems unlikely there will be much momentum for HASP II or even another round of foreclosure prevention policies in the near term. But as housing policy is designed going forward, better attention to what happens when housing and labor markets fall at the same time at scale will be a hard learned lesson.