The backbone of the Obama administration's plan to salvage the housing market is a program in which lenders reduce borrowers' monthly mortgage payments down to a more manageable percentage of their income. In essence, the administration is betting that troubled borrowers will keep paying their mortgages as long as they can afford them--regardless of whether or no the investment in underwater.
In that sense, the plan is a bit of a leap of faith. The practice--known as "loan modifications"--is a controversial one; especially after a top federal banking regulator produced data last December showing that more than 50 percent of loans that were modified in the first quarter of 2008 had gone bad again within six months. And the bet looks even more risky when you consider the following figures that the Office of the Comptroller of the Currency and the Office of Thrift Supervision released Friday in their fourth quarter mortgage performance report:
[Check out 6 Reasons Modified Loans Are Going Bad Again]
Consistent with last quarter’s findings, the report also showed that re-default rates on modified mortgages were both high and rising during the first three quarters of 2008, with loans modified in the third quarter showing the highest re-default rates. For example, the percentage of modified loans that were seriously delinquent (60 or more days past due) after eight months was 41 percent for loans modified in the first quarter and 46 percent for loans modified in the second quarter. The trend appeared to continue for loans modified during the third quarter.
So mortgage modifications don't work, right? Unfortunately it's not that simple. Thing is, a borrower that gets a "mortgage modification" doesn't necessarily get a lower monthly payment. For 2008, nearly a third of borrowers who received modifications saw their monthly mortgage payments increase. (Twenty-seven percent of modified monthly payments were unchanged, while 42 percent decreased.) A modified loan could result in a higher monthly payment in any number of ways. For example, a lender could roll the missed payments back into the loan balance. But a modification that doesn't lower the monthly payment is no help to an already-troubled borrower. And since only 42 percent of modifications reduced such payments, the elevated re-default rate isn't all that stunning.
Not surprisingly, the OCC and OTS report shows that borrowers whose loans were modified to reduce their monthly payments had an easier time staying current:
Re-default rates were consistently lower for modifications that resulted in lower monthly payments. When modifications decreased monthly payments by more than 10 percent, only about 23 percent of the loans became seriously delinquent six months later. By contrast, some 51 percent of the loans in which payments remained unchanged were seriously delinquent after six months. The comparable number for loan modifications in which payments increased was 46 percent.
The Obama plan requires participating lenders to reduce monthly payments down to 31 percent of the borrowers' income. So, assuming that lenders, servicers and investors go along with it--and that's a huge if--loans modified under the plan should have lower redefault rates than those in the OTS/OCC study. Will that make the program a success? Tough to say, the country has never before seen such a sweeping loan modification effort. (And a 23 percent redefault rate is still astronomically high.) But loan modifications that actually reduce monthly payments certainly increase the chances of the program's success.