Bad News for the Fed’s Plans: Mortgage Modification is not Working

The Federal Reserve wants to lower long-term consumer interest rates. To this end, it has cut its policy rate to zero; engaged in any number of asset swaps with lending institutions; and, recently, begun outright purchases of GSE debt to put more direct pressure on mortgage interest rates. These policies, particularly purchases of GSE debt, seem to be working: mortgage interest rates have recently fallen to near record lows.

Of course, the Fed does not want to lower interest rates just for the sake of having lower rates. It wants to increase economic activity. And, in particular, it wants to help the housing market. The link is clear: lower mortgage interest rates raise housing affordability. Cheaper housing boosts demand. We observed a tepid increase in housing activity in February, whether a statistical fluke or a real turning point we shall see as the spring data comes in.

The average homeowner, through refinance, can take advantage of the Fed’s program and lock in for 30 years very low interest rates. A one percentage point reduction in interest rates will reduce the payments of an average homeowner about 10 percent per year. This cost reduction will push some households to buy a first home or to move up to a larger home. [Of course, this savings comes at an upfront cost of about 3 percent of their outstanding mortgage (personal survey of 10 mortgage issuers based on median house price and 80% down – prime borrowing only), raising the average debt level of the household sector.]

The Fed’s program, however, is likely to help the marginal homeowner only slightly. It seems to me that, at this moment in time, the most important marginal homeowner is the household that can no longer afford their house. When they stop making payments, their house eventually contributes to the inventory of unsold homes, lowering house prices and pushing more households to foreclosure.

It might be hoped that the lower interest rate would ease the payment burden of at risk households and reduce the number of foreclosures; however, new data from the OCC and the OTS indicate that interest rate reductions are not sufficient to substantially reduce the number of delinquent mortgages.

A reduction in mortgage interest of 1 full percentage point reduces the payment burden of households by about 10 percent. Data released in the OCC’s Mortgage Metrics report, reveal that more than 30 percent of mortgages modified such that the payment is reduced by less than 10% re-default within a few months of the modification.

Mortgage Metrics

The picture below is taken from the Mortgage Metrics report. The data are surprising: mortgage modification does not work at reducing mortgage delinquencies. After 9 months, more than 60 percent of modified mortgages are in default. And, we don’t know how many of the modified loans would have continued making payments in any event: not all delinquent loans go into foreclosure.
I think this number, by itself, goes a long ways toward understanding the low level of workouts from banks. Banks were likely aware of the low success rate and are therefore hesitant to undertake the effort needed to modify a loan. [I hope the State of Florida is paying attention. This applies directly to their new forced mediation programs.]
As striking as the relatively high level of defaults, the percentage of loans defaulting increased over the first three quarters of 2008. Over this time frame, the government, in the form of moral suasion, pushed lenders to increase the number of modifications. They responded; the number of modifications rose from 208 thousand in Q1 to 301 thousand in Q3. Apparently, however, to get this increase the lenders had to seek a broader pool of modification candidates and the deterioration of that pool is then predictable.

Perhaps one of the main problems with loan modification is that the majority of actions do not reduce the household’s mortgage payments. A whopping 32 percent of modifications leave the household with higher payments after the action. It’s clear to me why loan modification does not work if the payments don’t go down.

But what’s perhaps more surprising is that even loans with a reduction of 10 percent or more in payments still default at very high rates. After 9 months, 26 percent of loans in this category are delinquent. This number is going to worse over time because later vintage modifications do not perform well.

Here are my thoughts: I suspect, but do not know, that most of the loan modifications either reduce the interest rate faced by the household or extend the term of the mortgage. I suspect that very few of the modifications try to adjust the principal and that almost none of them ensure the household is actually above water following the modification. Households with negative equity positions are going to default in disproportionately large numbers.

By the way, for the first time in this cycle, the number of prime mortgage serious delinquencies is greater than that of any other category and the default rate on prime mortgages more than doubled between the first quarter and the fourth. I don’t think we are done with this housing cycle yet. Remember, the labor market did not take its nose dive until the fourth quarter. The serious delinquencies induced by this fall will not show up until at least the first quarter and more likely the second.

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.