This article discusses the existing and potential incentives for lenders to cram down the balance of a homeowner’s loan in lieu of a loss on foreclosure, and asks why lenders have traditionally been so reluctant to undertake such negotiations.

It is a well known fact that lenders and loan servicers have a marked aversion to loan renegotiations. Lenders do everything they can, and often deliberately avoid doing anything at all, to escape direct contact with the borrower. Federal incentives to encourage loan renegotiation have had low-level and mixed successes, at best; at worst, the loan modifications that result tend to lead to eventual foreclosure. The vast majority of homeowners who do achieve some form of loan modification are unable to reduce (cram down) the balance on their loans, and most redefault on their modified mortgages within six months.

It is an equally well-known fact that foreclosure is an expensive process for lenders and, under 2010 resale market prices, dramatically more expensive and (once initiated) unstoppable than any lost income from an individual loan modification. This second fact has led to some confusion among policy-makers and economists, who cannot comprehend lender rationale for avoiding loan modifications. A variety of economic hypotheses exist to explain lender aversion towards modifications, but policy makers are only beginning to comprehend the basis for this somewhat counterintuitive situation.

One of the most common explanations for the general failure of mortgage holders to renegotiate real estate loans in the face of high foreclosure and real estate owned (REO) resale costs is the high degree of securitization in the current mortgage markets. As loans were bundled into pools funded by Wall Street bankers’ issuing mortgaged-backed bonds (MBBs) to thousands of investors, and ownership within the pools was divided between assorted parties (tranches) with differing priorities for claims on principal and interest, it became more difficult for those assorted tranches to agree to act in unison to prevent foreclosure, even when such an action was in their best interest. Much current policy, such as the federal Making Home Affordable (MHA) Plan, is based on this theory: if the road is cleared by small incentives, economists seem to say, lenders will rush to help buyers, and help themselves in the process.

A recent report from the Atlanta Federal Reserve embraces a less rosy idea of what constitute lenders’ best interests. This report confirms an explanation for the lack of loan modifications that has already been discussed in previous first tuesday articles: the best interests of lenders and homeowners rarely coincide since their positions in the mortgage transaction are adversarial. It is true that lender costs from foreclosure, which include the difference between the loan amount and the REO resale value of the secured property, as well as numerous fees involved in the foreclosure process, are often extremely high. Unfortunately for borrowers, and for lawmakers, it turns out that lender costs from loan modification are often even higher. Therefore, lenders avoid modifications not because modifications themselves are so complex or difficult to arrange, but simply because lenders have no purposeful financial reason to pursue them.

As first tuesday has previously reported, economists often fail to consider the full lender costs for loan modifications. These costs include not only the expenses brought about by eventual foreclosure and REO resale when the modifications fail (as they most frequently do), but also the costs of creating modifications for homeowners who would never have required foreclosure in the first place, what lenders consider the moral risk of making even one modification. Lender costs are only increased if the modification involves a reduction of the loan’s value to meet the depressed value of the home in a cramdown. This is why lenders never allow cramdowns, and why they are so violently opposed to the granting of court-authority to reduce principal amounts to the value of the secured property. [For more on lender-buyer adversity and loan modifications, see first tuesday’s report: “Reducing Foreclosures”].

Recently, the federal government has instituted changes to its MHA program which may eventually lead to increased cramdown activity. These steps include measures to make short sales (loan discounts on payoff) simpler and more appealing for lenders, by implementing a standardized process for short sales from start to finish. The MHA additions also include monetary incentives for short sales, such as:

  • $1,000 to lenders;
  • $1,500 in ‘key money’ to the homeowner, and no loan-to-value (LTV) maximums to abide by;
  • $3,000 to second lien holders; and
  • a non-negotiable fee for the broker involved, if included in body of the short sale agreement. [See first tuesday Forms 150-1 and 156-1]

Adding a short sale loan discount remedy to the MHA Program lays the groundwork for a logical leap toward cramdowns. After all, if the lender is willing to discount the loan on the homeowner’s sale of the property to a new owner/buyer, then why not offer the same discount to the current owner by a loan modification (if he is qualified to remain in the property), and end up with fewer disruptions for all involved?

Cramdowns remain the most effective method of averting foreclosure. Legislators are aware of this fact even if political realities, due to the desires of their donors, prevent them from making widespread government-encouraged cramdowns commonplace. Federal efforts to encourage short sales are a step in the right direction, although many more steps are yet to be taken, and much time has yet to pass, before this property ownership crisis will end.  Only then will the real estate market and its brokerage community be able to get back to normal open-market transactions between ready, willing and able sellers and buyers.  And please, no speculators.

For more information on lender thinking, and possible policy solutions that actually make sense, see first tuesday’s report on “Negative Equity and Foreclosure”.