Bad News for the Foreclosure Crisis

Take a look at this chart released by John Duggan from the OCC today. (Here is Duggan's speech.)

Let me explain, the OCC asked lenders what percentage of borrowers re-defaulted on their mortgages after modification was complete, and how quickly did they do so? The chart shows the results. Each point of the line represents the number of borrowers who were thirty or more days delinquent following loan modification.

The results are stunning and unambiguously bad news for all of the loan modification plans out there. One-fifth to one-quarter of all modifications slip immediately back into default; that is, thirty days after modification they are thirty days behind. By six months, 50 percent of the borrowers are delinquent. The upward sloping line indicates that, at least on average, they are never returning to good status. No wonder the loan industry has not been enthusiastic about working out mortgages: Loan modification does not work.

Importantly, we do not know why the modifications are failing. The OCC is following up with lenders now trying to answer this question. In his speech, John Duggan offerred the following thoughts:

Is it because the modifications did not reduce monthly payments enough to be truly affordable to the borrowers? Is it because consumers replaced lower mortgage payments with increased credit card debt? Is it because the mortgages were so badly underwritten that the borrowers simply could not afford them, even with reduced monthly payments? Or is it a combination of these and other factors?

So, we need more data to distinguish between the different possibilities, but let me offer a speculation of my own: many of the borrowers remained underwater after the modification. Even the best modification plan, the Hope for Homeowners, the most the principal is ever reduced is to the value of the home. This means the borrower who would rather sell than default must come up with 6 percent or so of the value of his home, in cash. For the rest, what difference does it make if the lender lowers the interest rate a few percentage points if the mortgage is still worth way more than the house. There is no monetary incentive to make payments.

There is no easy, free solution to the crisis. Home values have fallen and they are likely to fall a lot further. Falling prices mean more foreclosures and more foreclosures mean falling prices. I am still on the fence as to whether we should bail out banks and homeowners by stopping the foreclosures, but if we are going to do it then get it right. It takes a fiscal transfer from good, reliable, safe households to households that recklessly over borrowed. The transfer has to be sufficiently large that the household is above water after the modification.