Credit rating agency Standard & Poors has taken a closer look at the effect of loan modifications on borrowers and mortgage-backed bond (MBB) investors. Turns out, cramdowns are cool.

Loan servicers performed over 3.1 million loan modifications from 2008 through March of 2013. Two million of these loan modifications were processed as part of the Home Affordability Mortgage Program (HAMP). Considering HAMP was extended through late 2015 and a housing price dip is on the horizon, S&P believes modifications will continue at pace into the foreseeable future.

There are two basic types of loan mods performed by servicers:

  • interest rate reductions; and
  • principal reductions (cramdowns).

S&P found servicers heavily favor offering rate reductions, but leaving the actual unpaid principal intact. Forty five percent of all loan modifications performed since 2009 have been interest rate reductions. Principal reductions only account for about 10% of modifications over the same period.

Interest rate reductions are undoubtedly popular with lenders, but they don’t do much good for borrowers. Loan modifications that only lower a borrower’s interest rate ignore the central problem of lost equity, which leads to a re-default rate of 50%. As borrowers lose equity, their incentive to continue to pay goes up in smoke.

Cramdowns, on the other hand, benefit the borrower considerably, according to S&P. The likelihood of re-default is lower in the case of a cramdown since the borrower’s equity is restored making a traditional sale possible.

S&P found that neither cramdowns nor rate reductions disproportionately affected MBBs. Each loan modification presents its own type of risks to bond investors, but cramdowns are by no means riskier than rate reductions (as many have argued.)

Here’s how S&P puts it:

Any type of modification brings with it nuances that may benefit the borrower while having a varied impact on investors.

The deflation of the speculator-driven mini-bubble will bring on a new batch of loan modifications. Unfortunately, those modifications are likely to be ineffectual rate reductions of the HAMP variety — the continued folly of wrong-headed, ideological housing policy. That is, unless Ed DeMarco finally gets his walking papers as the public has been demanding for over a year now.

With the recent demolition of the filibuster in Congress, this might happen sooner than we think.