The Federal Housing Finance Agency has attributed the poor mortgage modification record of servicers to their low compensation and wants better incentives to modify loans. The agency is only partly right.
Successful modifications often require reduction of outstanding principal. According to Amherst Securities, the redefault rate on modified mortgages has been 70% where only the interest rate was reduced but significantly lower where principal was reduced. Amherst also concludes that negative equity is the largest driver of foreclosures. But servicers are often affiliated with the bank that holds the mortgage, so they are reluctant to reduce principal where it would result in a loss to the bank. The government-sponsored enterprises, and taxpayers, would also suffer losses from principal reduction. This problem will persist until the banks and the GSEs write down their mortgages to their true values.
One partial solution might be for the banks and GSEs to retain a participation in the homeowner's profit above the reduced principal amount on refinance or sale. Although this won't reduce GAAP losses, it might reduce regulatory accounting losses that require raising additional capital.
Another obstacle is the concern that underwater homeowners who can afford to pay their mortgages will default because they feel entitled to a principal reduction under the Home Affordable Modification Program and because the government is giving it to others. These "strategic defaulters" are facilitated by programs in many states that require mediation as a condition to foreclosing. These programs favor homeowners — a politically popular position — and have prevented foreclosure to pressure lenders to reduce principal even where homeowners can meet the original mortgage terms they agreed to.
Another obstacle to reducing principal is the fairness issue — the outrage at reducing principal for irresponsible borrowers but doing nothing for responsible homeowners who pay their mortgages.
Amherst has suggested two elegant solutions for both problems. First, impose a heavy tax on any profit the borrower realizes above the reduced principal amount on a refinancing or sale. A similar approach would be to remove the $500,000 exemption from capital-gains tax. Second, give a share of the borrower's profit to the lender that reduced the principal and took a loss.
Also, Congress should make it illegal for state mediation programs to prevent foreclosure where borrowers can afford to pay, and should make it a crime for borrowers to misrepresent their income in modification negotiations.
Any new compensation structure should provide incentives to obtain the best prices on short sales and foreclosures to minimize their downward pressure on home prices, because home purchases generate GDP growth.
Short sales and foreclosures also stabilize prices by clearing the market of unsold inventory and stimulating home construction, which is a major contributor to job and GDP growth. But megaservicers get paid only so long as their loans are outstanding, which operates as a disincentive to affect short sales and foreclose in a timely manner. This inaction is often attended by a lack of maintenance of the home, which depresses home prices. Any new compensation structure should provide incentives against unduly delaying foreclosures and short sales where modification is not possible.
The problems described above do not exist for private funds that buy underwater mortgages and use affiliated servicers that succeed only when the fund succeeds. Because they buy the loans at a discount, they usually don't take losses upon principal reduction, short sales or foreclosures. These funds seek to maximize their returns by, for example, reducing principal and modifying or refinancing the fund's loans and obtaining FHA backing on the new or modified loan. Also, these servicers are motivated to foreclose and do short sales in a timely manner at the best prices where modification is not possible.
The FHFA should consider all these issues when creating new fee structures for mortgage servicers.
