The Effect of Loan Modifications

Last Friday the Office of Thrift Supervision released a report about the effectiveness of loan modifications that should not have surprised anybody. The upshot of the report found that modifications that did not reduce monthly mortgage payments resulted in re-defaults in about 51% of cases, but that loan modifications that reduced borrowers' monthly mortgage payments resulted in a substantially lower rate of re-default, either 23% or 26%, depending on source. It should not take a government study to demonstrate the correlation between lowering monthly mortgage payments and lower rates of re-default on loans, but at least the measure of effectiveness is useful.

The report found that many loan "modifications" were actually forbearances, meaning that they did not alter the terms of the loan, but simply permitted borrowers to make missed payments at a later date, or factored already-missed payments into the borrowers' current monthly payments. The latter scenario actually increases borrowers' monthly payments. If the borrowers were already having trouble making payments, it should be no surprise that the failure to lower those payments does not alleviate the burden on the borrowers. As stated above, the report found that about 51% of borrowers receiving such modifications fell back into default within six months.

By contrast, loans that were truly modified to result in lower monthly payments for the borrowers resulted in much lower rates of re-default. When loans were modified so that the monthly mortgage payments were lowered by 10% or more, the rate of re-default six months later was only about 26%. That is half the percentage of re-defaults of the other category. Most of the articles describing the study did not specify how the loans were modified, but it appears to have been accomplished through lowering the interest rates and extending the life of the loans. In many cases, it appears that the monthly payments were kept lower by reducing interest rates. (See press release from the Office of the Comptroller of the Currency from April 3, 2009, listed at: http://www.occ.treas.gov/ftp/release/2009-37.htm.)

The 10% reduction to monthly payments appeared to be an arbitrary reduction level that is not tied to any particular level of the borrower's income. In such a case, it is not surprising that such a high percentage of even the modified loans continue to re-default. Many people have recently advocated identifying viable levels of mortgage payments based on the borrowers' income and then adjusting monthly payments to those levels. Such an approach is much more likely to establish viable levels for borrowers and to prevent re-defaults. However, many of those plans require lenders to forfeit some amount of principal from the loan in order to reach the targeted payment levels. Once again, I submit that my plan would facilitate the lenders' efforts to reduce borrowers' monthly mortgage payments, but would compensate the lenders in a fair manner for writing down the principal of the loans.