6 Reasons Modified Loans Are Going Bad Again

Top bank regulator says many reworked loans are defaulting for a second time.

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As the housing crisis continues gutting property values and tipping homeowners into foreclosure, lawmakers, community groups, and even government officials have been pressuring the Bush administration to step up its efforts to modify loans. By reworking the terms of mortgages--say, by extending the payment period or lowering the principal--troubled borrowers will be able to make their payments and remain in their homes, modification supporters argue.

In the face of higher delinquencies and mounting political pressure, a number of key private-sector players--Citigroup, JPMorgan Chase, Bank of America, Fannie Mae, and Freddie Mac--have recently introduced plans to bolster such efforts. (That’s on top of the Hope Now Alliance, the Bush administration’s voluntary loan modification program.)

So, how have modified loans performed so far?

Well, according to Comptroller of the Currency John Dugan--a top bank regulator--more than half of the mortgages that were modified in the first three months of this year went delinquent again within six months. “After three months, nearly 36 percent of the borrowers had re-defaulted by being more than 30 days past due. After six months, the rate was nearly 53 percent, and after eight months, 58 percent,” Dugan said Monday in a speech.

Why have modified loans gone bad again in such high numbers? Here’s a look at six factors behind the trend:

1. Overextended borrowers: Many of today’s most troubled borrowers are saddled with properties they were able to purchase only by overextending their finances through risky, adjustable-rate loans. Many of these borrowers got in so far over their heads that they won’t be able to make their payments even in the most generous of modification programs.

2. Underwater effect: While loan modifications have reduced monthly payments for some borrowers, they haven’t sufficiently addressed the issue of “negative equity,” where a homeowner owes more on his mortgage than the home is now worth, says Christopher Thornberg, founder of Beacon Economics. “The modifications that they are doing don’t solve the fundamental problem,” Thornberg says. “The fundamental problem is that people’s homes aren’t worth anything close to the amount of debt that they are carrying on the home.”

Homeowners who are “underwater” have an incentive to simply walk away from the house rather than continue paying off an investment that is losing value. Some borrowers could be telling themselves, “Well, gee, we’ve redone my mortgage, and it’s still underwater so why bother [paying it]?” says Richard Moody, chief economist at Mission Residential. At the same time, home equity can provide borrowers with a financial cushion in times of distress. “But you have all these people who are now underwater and they have zero cushion,” says Dean Baker, co-director of the Center for Economic and Policy Research. “So if anything goes wrong, they suddenly can’t pay their mortgage.”

3. Other debt: Some distressed borrowers aren’t just behind on their mortgage debt; they have other creditors--their credit card company or a student lender, for example--hounding them as well. Such borrowers, in many cases, will have to use any cash that lower mortgage payments free up to pay off these other debts, meaning they’re not getting much--if any--relief from the modification. “There are a lot of people that no matter how much you modify the mortgage, they are still not going to be able to deal with it because they have other serious financial problems,” says Bert Ely, a banking industry consultant in Alexandria, Va. “They have a lot of other debt like credit cards, home-equity lines, student loans [or] car loans.”

4. Moral hazard: Troubled borrowers who received a loan modification may simply be expecting a second round of modifications if they redefault, says Susan Wachter, a professor of real estate at the University of Pennsylvania's Wharton School of Business. “The moral hazard that is [potentially] operating is: For these households that are under stress, repayment plans have been negotiated, [so] the potential for renegotiating such plans upon default again exists,” Wachter says. Such borrowers could be thinking: “ ’I couldn’t pay before. I can’t pay now. Let’s see what happens,’ ” she says.

5. Too-tough terms: It’s also possible that loans weren’t modified aggressively enough to make them affordable to troubled borrowers, Moody says. “In other words, when they underwrite these mortgages, they are underwriting them at a principal and interest maybe upwards of 40 percent of monthly income,” he says, “as opposed to what would be a more normal 30 or 32 percent.” Such loans might be significantly more affordable than they were originally, but the payments could still be too costly for distressed borrowers.

6. Unemployment: The economic and employment outlook has deteriorated significantly over the past six months. Job losses could also be preventing borrowers with modified mortgages from making payments.

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