Mortgage Loan Modifications: Program Incentives and Restructuring Design

Mortgage defaults and home foreclosures remain a growing problem that undermines the nascent US economic recovery. Delinquencies continue to skyrocket, up 300 percent since the beginning of the crisis, and the contagion has spread to prime loans where delinquencies have risen to over 11 percent of outstanding loans. The resulting foreclosures have broad consequences: Individuals lose their homes, banks take losses on the loans, neighbors suffer as area prices go down, and localities lose on property taxes. The economics of modifying loans to avoid defaults appear strong: Lenders lose an average of $145,000 during a foreclosure compared with less than $24,000 on a modified loan. Yet the track record of modification programs has been surprisingly poor. Potential lawsuits over modifying loans in securitization trusts may be a less important obstacle than many claim. More significant are misaligned incentives that put mortgage servicers in opposition to both investors and borrowers, conflicts between investors holding different tranches of mortgage-backed securities (MBS), operational impediments, and problems in loan modification design that contribute to redefaults. Policymakers should improve reporting metrics to highlight servicers’ conflicts of interest, shift the emphasis of loan modifications from short-term fixes to making the new loans more sustainable, and use government resources to drive operational/capacity improvements in the industry.