Mortgage Foreclosures, Modifications, and Economic Recovery

With all the flurry surrounding the recently-announced preliminary settlement conditions for sought by AGs and bank regulators after the foreclosure crisis, it is interesting to note that the modification push that is the focus of that effort is losing ground in Congress.

The hallmark of the entirety of the proposed settlement is an attempt to give modification a permanent role in the delinquency and foreclosure process. Servicers are required to give a modification to the borrower if such an alternative passes the much-vaunted (and famously ill-defined) NPV test. In the event a borrower flunks the NPV test, they can challenge the decision and submit their own appraisals and other documentation, to be submitted electronically taken at face value without verification. All foreclosure activity must stop while this process plays out, regardless of the stage of a bankruptcy hearing or other ancillary proceedings.

The problem is that modifications have very little effect on borrowers in the aggregate. One third of HAMP modifications never make it out of the trial phase, and another half fail after that. In a 2007 white paper, I cited a fifty percent modification failure rate in the pre-crisis (bubble) market (http://ssrn.com/abstract=1027470). Hence, a two-thirds failure rate in the fallout is to be expected.

Such changes to foreclosure processes will, therefore, lengthen the foreclosure timeline from the current average of just over two years to three or longer, even where there is no longer a borrower who wants to retain the home. As I presented in the WSJ on February 24, compelling economic evidence shows that “…efforts to lengthen the foreclosure process will not substantially alter borrower outcomes. They will only extend a painful time for borrowers and the economy. During that time, uncertainty will prevent borrowers from moving on with their lives, including starting to pay rent and make purchases that would inject money into the economy.”

Servicers, banks, and mortgage investors already understand these realities. The problem is not that mortgage market participants wish modifications to fail, but that a stressed borrower that cannot afford their mortgage usually has more than an incremental problem of being short a few dollars this month (in fact, most servicers can accommodate such a problem). Rather, the borrower has lost their job or – in the case of many bubble-era mortgages – never had the income to begin with. As delinquent borrowers file financial data in bankruptcy proceedings they are revealing inadequate income – substantially deviating from that which would have been necessary to make loan payments – not only now but also at the time they borrowed the money to buy the home. Moreover, they still don’t have the income now (hence, they are filing for bankruptcy), so mere modification will not help.

Congress is finally coming to grips with this issue. HAMP, which draws funds from the Troubled Asset Relief Program, has helped more than 600,000 homeowners with permanent loan modifications in the past two years, but that is far short of the 3 million to 4 million President Barack Obama has promised to help. While foreclosure filings reached a record 2.9 million in 2010, the program has been criticized by government watchdogs including the Government Accountability Office, the investigative arm of Congress. According to Bloomberg, many Democrats are coming on board opposing HAMP, even as the White House in a statement last night threatened to veto the Republican-sponsored bills to abolish the FHA and emergency-loan bills.

The battle lines being drawn around modification are important for a number of reasons. First, it is not clear that the AGs and regulators seeking the settlement have the authority to impose and monitor many of the key terms, ranging from new requirements for notaries, new insurance regulations, and new bank procedures (regulators don’t regulate procedures, only outcomes) and even potential regulatory implications for Kinkos and Staples office centers to transmit modification documents for free.

Even where regulators are on board with the changes, regulations cannot technically be changed without following the rulemaking process that includes noticing the change and soliciting comments from the industry. The Obama administration is already under fire for EPA and other regulatory agencies overstepping their bounds to create rules that are interpreted by many to be beyond their authority, without economic cost analysis and in violation of standard rulemaking procedures that include public input and consideration.

In my opinion, the proposed settlement is similar, representing fundamental changes to property rights that will significantly disrupt US economic activity while having little real effect. Moreover, much of the settlement represents de facto “legislation” by the judiciary and regulators outside of Congress, where ample debate should take place and all voters’ interests are properly represented.

The banking industry is not opposed to modification. In fact, the industry, itself, has made great strides in developing modification tools, procedures, and best practices in the years prior to the crisis. But, as I wrote in my 2007 white paper, modification is not a panacea for our current problems. It may make more sense for markets and foreclosed borrowers to institute programs to help people move out of homes they cannot afford, assisting with relocation expenses and making sure they can still rent an apartment with their lower credit scores.

Instead of trying to prevent economic adjustment, it may be more useful to help the adjustment by looking honestly at housing market problems and incentives and forming realistic economic goals for recovery. While everybody needs a place to live, it is too much to expect everybody to be able to own a home.