Financial Update (Third Quarter 2009)

Atlanta Fed Economist Explores Mortgage Renegotiations

photo of couple and bankerOne widely touted approach to curbing the foreclosure crisis is mortgage renegotiation, an agreement in which a lender would perform a payment-reducing modification on a home loan that was in danger of foreclosure. Numerous policy actions have involved encouraging lenders to renegotiate loan terms to reduce borrower debt loads, yet relatively few of these modifications have taken place. To policymakers, the appeal of renegotiation is obvious: In theory, it helps borrowers and lenders at little or no cost to the government. So why are mortgage servicers reluctant to reduce the cost of the loans that might later cost them even more if the foreclosure process begins?

A recent Atlanta Fed working paper examines why loan servicers have been reluctant to modify the loans that are likeliest to eventually fall into foreclosure. The paper concludes that contract frictions in securitization trusts, a popular scapegoat in both the academic literature and the media coverage of the crisis, are not to blame.

Working Paper 2009-17
Audio icon Podcast with Kris Gerardi (MP3 11:24)

Examining renegotiation from the investor's perspective
According to the working paper by Kris Gerardi, an Atlanta Fed staff research economist and assistant policy adviser, Manuel Adelino, and Paul S. Willen, there may be a simple explanation of why mortgage modification is not more commonplace: "Lenders expect to recover more from foreclosure than from a modified loan," they write. Several reasons, which fly in the face of some commonly held assumptions, support this hypothesis, including:

  • about 30 percent of borrowers who are seriously delinquent for the first time "cure" without receiving a modification, which the authors say can be interpreted to mean that 30 percent of the money spent on any randomly given modification is misspent;

  • a large fraction of borrowers who receive modifications end up back in serious delinquency within six months; and

  • a borrower who faces a high likelihood of eventually losing the home will do little or nothing to maintain it or may even contribute to its deterioration,reducing the expected recovery by the lender.

Implications for homeownership policy
The authors conclude with their implications for policymaking. They say that the "safe harbor provisions," which are designed to shelter loan servicers from investor lawsuits if loans are modified, are not likely to have a material effect on the number of modifications done and thus will not decrease foreclosures meaningfully. Second, the authors say, if lenders believe that borrowers may self-cure without renegotiation or redefault after loan modification, the number of preventable foreclosures may be smaller than many believe.

August 31, 2009