The objective of a modification in residential-secured lending is to convert a troubled asset into a performing one. A well-implemented streamlined modification program will mitigate losses and enhance brand image, and it can show a positive return.
In November the Federal Deposit Insurance Corp. published the FDIC/IndyMac "mod-in-a-box" process for modifying loans. Major financial institutions have endorsed this approach and announced similar programs.
In light of the still-high delinquency and foreclosure rates, the introduction of HR 7326, the Systematic Foreclosure Prevention and Mortgage Modification Act, and the change in administrations, lenders should expect increased pressure to implement streamlined modification programs to assist residential-secured borrowers.
In traditional loss mitigation, every offer is customized for a borrower's individual circumstances. Today it must be systematized, with most offers based on approved policies and procedures that are applied consistently with judgmental decisions at a minimum.
The FDIC/IndyMac framework provides a pragmatic, systematic approach, incorporating analytics into a process that has become too large and too complex to be managed individually.
The goal is an affordable payment derived from verified income. A modification is specified that achieves the affordable payment through a combination of rate reduction, term extension, and principal forbearance.
The customer is offered the modification whenever the expected value of the modified loan exceeds the foreclosure value. This approach, called the net present value test, balances the borrower's need for a concession with the lender's need to recover the debt. Basically, the lender should be willing to grant a portion of the value above the foreclosure value to a borrower in order to convert a troubled asset into a performing one.
A streamlined modification process segments the pool of loans being considered into three groups: affordable, too much equity, and modifiable. The first group is eliminated, because the loans are already affordable. The second group is eliminated generally because the presence of sufficient equity makes foreclosure a better alternative. The modifiable group consists of borrowers who are generally in unaffordable, underwater loans.
A streamlined modification program must be integrated into a more traditional loss-mitigation process. Each institution needs to have a follow-on process for handling other options, such as deferments, payment and forbearance plans, and short sales.
Before the implementation, portfolio managers will want to estimate a modification program's performance, using portfolio analytics and simulation.
The redefault rate should not be used to compare the success of programs across loan pools with large differences in expected loss and foreclosure rates. This rate confounds two factors: the expected nonperformance rate on the underlying portfolio without modification, and the success at saving modified loans that would otherwise be nonperforming.
A modification works if a potentially nonperforming borrower becomes performing. Success should be measured by the reduction in volume of nonperforming assets relative to what would have happened without the modification.
The "moral hazard" effect will be relatively small in a carefully designed and consistently implemented modification program. This can be controlled through verification of income, value, and assets; the use of the net present value test, which limits the concession to the size of the loss under foreclosure; and analytics to ensure that each segment of the modifiable loans would have a high unit chargeoff rate if left unmodified.
Our experience with streamlined modification programs is that, if implemented properly, they are good for the borrower, good for the lender, and good for the country.