Boston Fed: We Don't Understand Foreclosures

If you’ve read it once, you’ve read it a thousand times. It’s the meme that it’s in the best interest of banks to modify loans and reduce principal since they will lose as much or more through the foreclosure process. Well, some fellows from the Boston Fed decided to see if that was indeed true, and guess what, it’s not the way the real world works.

Their study covers a lot of loans (60% of the mortgages originated between 2005 and 2007) and presents some conclusions that are not going to make anyone feel very comfortable about the housing market. Here is a summary of their findings:

1. Of the mortgages they reviewed only 3% had a modification that involved a principal reduction and only 8% received any sort of modification. That’s exceptionally low when you consider that half the loans they reviewed received foreclosure notices and 30% were actually foreclosed upon.
2. This one flies in the face of another piece of conventional wisdom. There was no statistical difference in the rate of modification between loans held privately and loans that had been securitized. Let me repeat that, no difference. After all the wailing about securitization as the evil spawn that stands in the way of homeowners getting a modification, it turns out it makes no difference.
3. Now here is what they found with regard to the foreclosure versus modify thesis. I am going to excerpt their findings rather than paraphrase:

Since we conclude that contract frictions in securitization trusts are not a significant problem, we attempt to reconcile the conventional wisdom held by market commentators, that modifications are a win-win proposition from the standpoint of both borrowers and lenders, with the extraordinarily low levels of renegotiation that we find in the data. We argue that the data are not inconsistent with a situation in which, on average, lenders expect to recover more from foreclosure than from a modified loan. At face value, this assertion may seem implausible, since there are many estimates that suggest the average loss given foreclosure is much greater than the loss in value of a modified loan.

However, we point out that renegotiation exposes lenders to two types of risks that are often overlooked by market observers and that can dramatically increase its cost. The first is “self-cure risk,” which refers to the situation in which a lender renegotiates with a delinquent borrower who does not need assistance. This group of borrowers is non-trivial according to our data, as we find that approximately 30 percent of seriously delinquent borrowers “cure” in our data without receiving a modification.

The second cost comes from borrowers who default again after receiving a loan modification. We refer to this group as “redefaulters,” and our results show that a large fraction (between 30 and 45 percent) of borrowers who receive modifications, end up back in serious delinquency within six months. For this group, the lender has simply postponed foreclosure, and, if the housing market continues to decline, the lender will recover even less in foreclosure in the future.

Before I add my two cents worth to this take a look at the implications that the Boston Fed group draws from their study:

We believe that our analysis has some important implications for policy. First, “safe harbor provisions,” which are designed to shelter servicers from investor lawsuits, are unlikely to have a material impact on the number of modifications and thus will not significantly decrease foreclosures. Second, and more generally, if the presence of self-cure risk and redefault risk do make renegotiation less appealing to investors, the number of easily “preventable” foreclosures may be far smaller than many commentators believe.

There’s little point in belaboring the obvious point here. The administration’s plans for mortgage modifications would appear to be much less achievable than they have, at least, indicated they would be. To the extent success in preventing foreclosures is part of their recovery plan this study might indicate that piece is at least in peril, which would of course render the rest of the plan somewhat less effective. So far as the mortgage market goes, it’s fair to assume that it is in for perhaps even a rougher ride than even the most pessimistic might have projected.

From a different perspective, this is a reaffirmation of sorts to be careful about taking as gospel everything you read in either the MSM or the blogosphere. To all of us it’s a lesson we too often forget about assuming something to be true simply because it makes superficial sense. And to the administration and the bureaucrats who design these programs it should serve to caution them that what looks good in a D.C. committee meeting might not square with the real world.

Comments

[Neil459:]

The key is something government never gets. From the article, "This group of borrowers is non-trivial according to our data, as we find that approximately 30 percent of seriously delinquent borrowers “cure” in our data without receiving a modification."

When the Government offers something for nothing people will take it whether they need it or not. This applies to welfare and many other government benefits. Guess what would happen if 30% of our government welfare costs went away?

Jul 08 08:12 AM

[simplesimon:]

If you would, stay on top of this, Tom. A huge number of us have been watching this to see what happens,.. if anything substantive or helpful. I think I'm correct in assuming most of us are confused. Off hand, I only recall that modification of delinquent loans were targeted at those falling behind, and not available for those who are managing to remain current...seems fairly logical that if one is delinquent now, they may well be 6 months after the modification. It does sound good on the surface of it - to reduce the principle and the monthly payment -and thereby free up disposable income...better than foreclosure, and abandoned homes being trashed by vandals. Please...tell us more.

Jul 08 08:49 AM

[nobull:]

Thx for the article.
Ofcourse, the govt operates for headlines and dramatic effect - sound logic, reason and ethics are secondary factors. And a socialist govt like this one will go to any lengths possible to spend public money to prove the govt is the answer.

Jul 08 08:56 AM

[Tim Plaehn:]

Excellent article and commentary! If the government wants to reduce foreclosure rates they need to come up with an "across the board" modification policy. All mortgage holders in whatever classification get the same rate or principal reduction. Then the banks do not have to decide who is a good candidate for modification. This would be a better use of stimulus money than the last plan.

I am not advocating for this type of plan. My point is if the powers that be decide to push for modifications, this is the way it should be structured. Let me make a hypothetical proposal.

Take all of the Freddie and Fannie guaranteed mortgages originated in 2004 through 2006. Reduce the interest rate to 1% for 2 years, banks eat the loss of income. Reduce the principal balances 10%. Uncle Sam pays for the lost principal. Anyone who walks away or short sales from a modified mortgage cannot get another government backed loan for 15 years. People in trouble would be able to make their payments again. Good payors get a nice bonus and future equity on their homes. Foreclosure activity would dry up. Home prices would start to rise. Just an idea.

Jul 08 09:25 AM

[rm:]

[We refer to this group as “redefaulters,” and our results show that a large fraction (between 30 and 45 percent) of borrowers who receive modifications, end up back in serious delinquency within six months.]

That's actually lower than the numbers reported from other sources. The OCC's report was 58%.

Re-default was less of a problem during the go-go days, as the property would likely be worth more with the passage of time.

Now, the reverse is true, compounding the losses on the fall-throughs.

There are solutions to the problem of re-default, but they take a substantial amount of time and effort. But rolling up the sleeves is not very popular, and it's a concept that's hard to sell.

Jul 08 10:02 AM

[J. Crighton:]

Or we could just continue to throw money at the problem, I know I know, that hasn't really worked much before . . . but MAYBE if throw an unimaginably large ammounts of money at the problem it will work out this time.

I like previous posters idea about reducing the principal balances by 10% although I would adjust it to all private mortgages not just the ones currently owned by the Gov since the problem isn't sole contained to the gov't owned mortgages.

Admitedly the pp solution would be a bit more do-able since the Fred & Fan mortgages are essentially owned by the gov the gov can do as it pleases, almost.

I figure that and throw in say a six month period or so where the gov't stops all with-holding taxes to throw some cash into the working part of the populations wallets to help pay the bills etc.

Jul 08 10:19 AM

[Gregman2:]

"...on average, lenders expect to recover more from foreclosure than from a modified loan." Hence, lenders must be forced to modify with the real threat that bankruptcy mod affords. Hey, no one likes this. The moral hazard issue on this sucks. But it's a Hobson's choice.
The general recovery will occur faster if write downs start to happen fast.

Jul 08 12:25 PM

[yk__:]

Another issue - the system was always geared towards foreclosing at maximum equity loss. This makes sense if the loan+expenses can be recovered easily, but the homeowner's remaining portion after the foreclosure sale needs to be minimized (punish the defaulter). Foreclosure sales were not traditionally heavily advertised, and the cash requirements and sales conditions (no time to review the property) reduce the recovered equity to a minimum.
This system does not work well when house equities are upside down.
The banks work around this by retaining the property (REO). That does meet the target of causing maximum damage to the defaulter, but also does not work very well for the banks.
The system will not change as long as the government bails the banks out. Self-interest works only when you are exposed to the results of your mistakes.

Jul 08 12:29 PM

[Xyrus:]

I'd be interested in the number of people who are just walking away from properties, even if they can continue to make payments.

After the last big crash in real estate in the early 90's, it took some areas more than ten years to recover (and some of that recovery was the new bubble).

So what I think a number of people are doing are looking at how underwater they are and whether or not their home will recover in 7 years (when a foreclosure falls off your credit history).

For someone who has lost 20-30% of their equity so far, having a foreclosure on their record for 7 years might appear to be the better deal, especially when it seems clear that the home prices won't recover in that period.

A foreclosure is bad, but if you otherwise have stellar credit you can recover from it quickly enough. In a couple of years, you could buy a home for a lot less.

I'm not saying that this is a good thing. But if you had a home in Vegas or Florida that has lost 50%+ of it's value, then walking away might not sound like such a bad idea.

~X~

Jul 08 01:59 PM

[Mark54:]

Someone help me out here...
If the loan is on balance sheet and it gets a principal reduction, how does it get accounted for on the income and balance sheet of the bank? If this loan is securitized in an agency name what are consequences to the bondholder? What if its private labeled?

Jul 08 09:04 PM

[Tom Lindmark:]

If there's a reduction in principal the asset is written down and the charge is recorded either against the loan loss reserve or income. Most likely the loan loss reserve but remember that account is funded by income.

Private label means it's not securtized and is on the books of the bank.

If the loan is securitized the bondholder would see a reduction in his collateral and income from that loan. The overall effect on the bondholder is going to depend on which tranche he holds and the overall performance of the entire portfolio. Given enough defaults even those holding the most senior tranches could begin to see cash flow fall below contractual rates.

Jul 08 09:26 PM

[kebu77:]

"The second cost comes from borrowers who default again after receiving a loan modification. We refer to this group as “redefaulters,” and our results show that a large fraction (between 30 and 45 percent) of borrowers who receive modifications, end up back in serious delinquency within six months."

Since very few of these mods involve principal reduction, i.e., meaningful relief, the experiment has yet to be run. What is the redefault rate among the minority of loans where the mod involves a break on the principal?

When the countervailing pressure of bankruptcy, and bankruptcy attorneys' involvement in the mod process, is allowed for homebuyers on the same basis as residential property investors and commercial real estate investors/developers, a meaningful case-by-case loan mod process could take place that, beneficially, would benefit both borrowers and lenders/investors.

The legal prinicple is that disputes are best settled at the lowest level, e.g., an out-of court bankruptcy settlement or pre-bankruptcy loan mod settlement.

This, rather than some grand top-down government-run scheme that, due to lobying influence, is compromised so much as to little targeted relief (while, at the same time, benefitting folks who could not get a low-level settlement due to their financials - - you walk-away artists, we know who you are).

Jul 09 10:34 AM