Why Don't Lenders Renegotiate More?

A new 41-page study examined data from thousands of mortgage loans and concluded that current political incentives for servicers to modify mortgages are ineffective. Most importantly, the study found that the traditional explanations for why servicers are not modifying more loans are wrong. The answer proposed by the study is more simple and mundane: the servicers still expect to make more money by foreclosing than by modifying -- even if the servicer takes a hit on both the depreciated property value and the legal cost of foreclosure. The paragraph summarizing the findings explains:

[W]hat is the explanation for why lenders do not renegotiate with delinquent borrowers more often? We argue for a very mundane explanation: lenders expect to recover more from foreclosure than from a modified loan. This may seem surprising, given the large losses lenders typically incur in foreclosure, which include both the difference between the value of the loan and the collateral, and the substantial legal expenses associated with the conveyance. The problem is that renegotiation exposes lenders to two types of risks that can dramatically increase its cost. The first is what we will call “self-cure” risk. As we mentioned above, more than 30 percent of seriously delinquent borrowers “cure” without receiving a modification; if taken at face value, this means that, in expectation, 30 percent of the money spent on a given modification is wasted. The second cost comes from borrowers who redefault; our results show that a large fraction of borrowers who receive modifications end up back in serious delinquency within six months. For them, the lender has simply postponed foreclosure; in a world with rapidly falling house prices, the lender will now recover even less in foreclosure. In addition, a borrower who faces a high likelihood of eventually losing the home will do little or nothing to maintain the house or may even contribute to its deterioration, again reducing the expected recovery by the lender.

The full article is available on the web site of the Federal Reserve Bank of Boston at http://www.bos.frb.org/economic/ppdp/2008/ppdp0904.htm.