As the mortgage industry begins modifying troubled loans in greater numbers, early rounds of modifications are coming in for performance reviews.
For the most part, public discussion of modifications has focused on the ability and willingness of servicers and investors to make them. For several reasons, including the still undeveloped track record for modifications, less attention has been paid to the outcomes of those that have gotten done.
A handful of analysts and academics who have studied which types of loan modifications work have found that some of the most common changes — reducing or freezing the interest rate and allowing missed payments to be rolled into the balance — often fail to prevent the borrower from defaulting again.
These are, of course, high risk loans by definition. But one aspect of some modifications points to why the default issue can rearise so quickly. The addition of arrears and fees to loan balances can actually increase monthly payments, a situation that leaves strapped borrowers no better off from a monthly cash-flow perspective. (Not all lenders charge fees on modifications. Bank of America Corp., for example, waives fees on the Countrywide Financial Corp. loans it is modifying under an agreement with state attorneys general.) Also, in an environment where house prices are falling, higher loan balances can erode or wipe out a homeowner's equity.
"We're going backwards," said Alan White, an assistant professor at Valparaiso University School of Law. "The voluntary modifications are putting people underwater more than they already are and those terms are contributing to the failure rate."
Prof. White said he examined the September and October remittance reports on $4 billion of bonds backed by subprime and alternative-A mortgages. Of the loans that were modified, roughly 72% received some form of "negative prepayment" that increased the principal balance.
He and others said that the most effective modifications are the ones that reduce principal as well as the interest rate. But principal reduction remains rare.
Rod Dubitsky, the head of Credit Suisse Group's asset-backed securities research division found that only two servicers — Ocwen Financial Corp. and Goldman Sachs Group Inc.'s Litton Loan Servicing LP — are doing it in any great numbers. "It seems that the momentum in mods is taking principal forgiveness off the table," Mr. Dubitsky said.
Servicers are less likely to make loan modifications that result in lower payments than those that result in higher payments, he said.
In his own analysis of monthly trustee reports from 19 servicers, Mr. Dubitsky found that about 30% of borrowers who received any type of modification in the fourth quarter of last year became 60 or more days delinquent within eight months.
Of the loans that received "traditional" modifications (rate reductions or capitalizations of past-due payments) resulting in higher payments, 44% defaulted within that time frame, he said. By comparison, the rate for principal reductions was 23%. Another group of modified loans — hybrid adjustable-rate mortgages whose rates were frozen or did not rise as much as originally planned — performed slightly better, but Mr. Dubitsky said most of those had not defaulted before modification.
Some servicers acknowledge that principal reduction would be a more effective way to prevent foreclosures, but they say their hands are tied.
"The guys in the trenches will tell you that if you don't offer some level of principal forgiveness to the borrower who is upside-down on their loan, you will have a high failure rate," said Tom Marano, the chairman and chief executive of Residential Capital LLC. But "there are a lot of cases where the investor does not allow us to reduce the principal."
His Minneapolis lender, a unit of GMAC LLC, typically offers an interest rate reduction first. If the borrower still has trouble keeping up, ResCap will then recapitalize missed payments.
Mr. Marano suggested that one way to help underwater borrowers was to offer a deal in which investors would get a share of any future appreciation of the home in return for lowering monthly payments. "We need to offer the borrower something to keep them incented but not give them a free pass," he said. But ResCap has not tried this because investors will not let it do so, he said.
Negative equity is a major factor in determining whether a delinquency leads to a foreclosure, but historically it has not been found to prompt delinquency in the first place.
Mark Fleming, the chief economist at First American CoreLogic Inc., said that for owner-occupied homes, "under moderate levels of being underwater, most individuals would choose to stay put." He pointed to factors like the enjoyment and shelter people get from their homes, ties to the community, and the costs of moving.
But with the depth of home price declines, the question now is "how far underwater does a homeowner need to be to decide to walk away?" Mr. Fleming said.
Over the last year, he said, one of the largest drivers of foreclosures has been negative equity, which makes it impossible for people to sell their houses to pay off loans once they get into trouble after the loss of a job or a divorce, or any of the customary causes of delinquency.
In his study, Prof. White found that servicers forgave an average of $1,914 in unpaid interest and fees on modified loans. But they increased principal by an average $11,200, including interest on arrears, taxes, and insurance advances. Servicers will foreclose on a homeowner for a loss of roughly $121,000 a loan rather than forgive "a few hundred dollars" of debt, he said.
However, he acknowledged that the data on principal reductions is preliminary. "We can't really evaluate the success or failure of mortgage modifications that reduce debt, because there have hardly been any yet," he said.
Robert Simpson, the founder and president of Investors Mortgage Asset Recovery Co. LLC, an Irvine, Calif., audit and fraud analysis firm, said servicers may unwittingly be granting modifications to speculators.
"What the servicer often doesn't know is that the borrower owns 25 other properties," he said. Twenty percent of the audits he conducts turn up such undisclosed additional properties, he said.
During a recent interview, Mr. Simpson pulled up dozens of documents on a range of borrowers — a cab driver in Las Vegas, a hairdresser in Reno, and a motivational speaker in West Palm Beach, Fla. — who all borrowed $700,000 to $800,000 on multiple properties by inflating their incomes on loan applications.
Servicers need a protocol to determine which borrowers have too much debt and cannot be saved by a loan modification, he said. His cutoff is five times a borrower's income.
"If you're going to help these borrowers, you have to decide who you're going to help," Mr. Simpson said. "Someone who makes $100,000 a year cannot make the debt service on a $500,000 mortgage. They borrowed too much and we don't need to do any hand-wringing for them. Someone has to have the intestinal fortitude to call these loans dead."