Loan modifications have been a popular theme on the Mortgage Calculator blog for the last couple weeks, and I plan to continue in that vein with this post. I’ve already covered the process of having a “private” loan modified (one originated/owned by a private lender). Today, I’d like to overview the process for having a “public” loan modified.

First of all, let me explain what I mean by a public loan. I’m primarily referring to loans guaranteed by the Federal Housing Administration (FHA). These loans have historically been available to low-income borrowers, who can apply for a mortgage through the FHA to achieve down-payment assistance and or more affordable mortgages. The second category of “public”mortgages are those held by Fannie Mae and Freddie Mac. These mortgages have always enjoyed an implicit government guarantee. Since the government effectively took control of the mortgage giants, you could say that it has a vested interest in ensuring their solvency, at the very least.

Those that have FHA mortgages are perhaps in the best position when it comes to loan modification. Eligible borrowers typically enjoy a 30% reduction on the interest-accruing balance on their respective mortgages. For as long as they live in the home and stay current on the original mortgage, they are only required to pay interest on the other 70%. When borrowers move out or refinance, however, the entire balance comes due.

Of course, FHA borrowers still have to jump through the same hoops as normal borrowers in order to achieve a modification. In other words, it’s not the FHA that ultimately has the power to approve/deny a modification request, but rather the loan services, which are incentivized by the government to support the program. Still, borrowers who are not yet delinquent on their mortgages probably don’t have a shot of getting approved, and the same is true for borrowers whose financial situations are especially desperate. The most promising candidates are the ones in the middle of the affordability spectrum- those whose mortgage payments aren’t crippling and hence have a realistic chance of avoiding foreclosure with the help of a modification.

Those whose mortgages aren’t guaranteed by the FHA, but are owned by either Fannie Mae or Freddie Mac, are also in a fortunate position. Since Fannie and Freddie are in a government trusteeship, mortgage servicers don’t need the approval of private investors before approving a modification. [For those who aren't sure whether they fall into this category, you can enter your street address here to confirm]. Still, the mortgage services themselves must grant the approval, and as with FHA loans, they are compensated for the government for doing so.

Such servicers are looking for borrowers whose housing payments (principal, interest, taxes, and insurance) exceed 31% of gross monthly income. In this sense, borrowers whose income has fallen (but not disappeared) since taking out their mortgages, and those whose payments have increased (as a result of adjustable rate reset, for example) are the most likely candidates. Typically, such borrowers will have see their interest rate reduced to 2%, though loan balance/principal won’t be adjusted.

As with FHA loans, servicers are looking for borrowers that are in need of aid, but not desperately so. Borrowers without any income won’t qualify, because the risk of foreclosure will still be high after modification. Those with healthy savings or other assets also won’t qualify, since most servicers will judge them capable of making mortgage payments without a reduction. The key is “massaging” your financial position so that you fall into the sweet spot.

The much-maligned Federal loan modification program appears to be gathering momentum, as the Obama administration recently announced that 500,000 mortgage loans have now been modified. This was hailed as a milestone, and the administration claims that it was reached ahead of schedule. Given the program’s slow start (reported in depth by the Mortgage Calculator), it is certainly cause for celebration.

Leading the pack are Citigroup, Wells Fargo, and Lehman Brothers, which have modified 33%, 20%, and 33%, respectively of their eligible loan pools. According to a government report, “In the second quarter, 78% of loan modifications involved actually reducing borrowers’ payments, up from 54% in the first quarter,” which means that “mortgage servicers became less likely to merely add missed payments to the balance of a reworked loan.” Even better, lenders have modified more than two million loans outside the auspices of the government program, through the industry alternative, known as the Hope Now program.

According to the government, the program aims to be even more successful, in terms of both individual lenders and on an aggregate basis. The stated objective remains 3 – 4 million modifications. Towards this end, the government will continue to incentivize lenders and release “report cards” on their progress.

Criticism of the program continues to pour on from all sides, however. Most of it is centered on the notion that the program is both naive and undercapitalized. Asserts one critic, “Borrowers whose mortgages are modified tend to default on the new terms at a high rate. Of the estimated 4.5 million homeowners in foreclosure or headed there with mortgages 90 days or more delinquent, the program ultimately will save only 1 million of them.”

In addition, there is concern that a fresh wave of delinquencies and potential foreclosures threatens to outpace the government’s efforts. To this, Treasury Secretary Geithner offered the following hedged response: “While the pace of loan modifications now exceeds that of new foreclosed loans, a ‘large number of families’ remain at risk of losing homes they might be able to afford if they could change their mortgage terms.”

There is even criticism coming from within the government, much of which is grounded in familiar partisan battles. Republican lawmakers argue that the $75 Billion budgeted for the program is wasteful and unnecessary, while their Democrat counterparts insist that additional funds need to be allocated. Despite the disagreement, “A Congressional Oversight Panel formally urged “Treasury to reconsider the scope, scalability and permanence of the programs designed to minimize the economic impact of foreclosures and consider whether new programs or program enhancements could be adopted.”

Finally, there are concerns that the program continues to benefit lenders and servicers, at the expense of borrowers. Lenders reap financial rewards for modifying loans even when the result is an increase in debt for the borrower. “These Treasury people are all from Wall Street, and they’re not doing anything but protecting Wall Street. They don’t care in the least about protecting homeowners,” argued one lawyer. The government, however, is doing its best to make sure loan modifications are carried out in an upright manner, and is in the process of officially prohibiting the charging of upfront fees in association with modifications. Progress is slow, but at least it’s progress.

Here at the Mortgage Calculator, we try to provide timely updates on the government’s loan modification program. Our last post, on August 6, (”Loan Modification Program could Receive Boost“), detailed the program’s shortcomings, which were responsible for the program’s dismal 9% participation rate. Since then, we’re happy to report that the program has really taken off, as the largest lenders have been shamed by the federal government into submission.

According to Bloomberg News, “Bank of America Corp. and Wells Fargo & Co., among the worst performers of banks in the U.S. government’s main foreclosure prevention plan, stepped up their pace of mortgage modifications by at least 60 percent in August.” Leading the pack is Morgan Stanley’s mortgage origination unit, which has modified over 40% of eligible loans, defined as owner-occupied homes, with a pre-2009 conforming mortgage that is in danger of “imminent default.”

As always, the devil is in the details, since a loan modification doesn’t necessarily lower the risk of default, and doesn’t even translate into a lower payment. “Of loans modified from Jan. 1, 2008, through March 31, 2009, monthly payments increased on 27% and were left unchanged on an additional 27.5%…Many modified mortgages fall delinquent — 25% to 40%, depending on the type of mortgage — often because of homeowners’ loss of income or additional outstanding debt…”

There are a few reasons for these outcomes. First of all, when executing loan modifications, lenders can choose between lowering one’s interest rate (temporarily or permanently), extending the loan term, and cutting principal from the loan amount. In theory, all would seem to lead to lower payments, but as the statistic above attests to, this is the case less than half the time, due primarily to the adding back of deferred taxes. Astonishingly, over 90% of loan modifications lead to higher principal balances.

Advocates argue that this represents the best approach. They point out that mortgage problems for many are a temporary result of unemployment, rather than long-term financial hardship. “A lot of what’s being done is a misplaced focus on modest, long-term relief when what they need is fast, short-term, massive relief (due to job loss),” maintains one economist. This philosophy is reflected in Bank of America’s approach to loan modification, which offers “mortgage forgiveness for three to six months in hopes the borrower will find a new job in that time.”

Those on the other side of the debate argue that this misses the point, and that the focus instead should be on “permanent debt reduction.” Many have begun to direct their attacks on the industry’s Net Present Value model, which is used to asses whether a loan modification is ultimately in the best interest of the lender. According to critics, this model is overly conservative, and leads to an overly high rate of rejection. At the very least, it confirms what cynics have maintained all along- that the mortgage lending industry still does not remain behind the loan modification program.

There’s even a small minority of critics who insist that loan modifications are a bad deal, on the grounds that it damages the credit of borrowers. “Under reporting guidelines set forth by the credit bureaus and the Consumer Data Industry Association, your loan modification will be reported as a ‘Partial Payment Plan.’ Under the FICO scoring method, that designation will lower your credit scores, even if you have never missed a payment.” From a credit standpoint, then, loan modification is not much different from foreclosure that far away from foreclosure, and might ask some to consider whether the consequences justify it.

Outside of this debate are the millions of people still waiting to receive modifications. For every borrower that is emerged “victorious” from the maze of requirements, there are at least 10 more who are stuck in “loan modification hell,” as one columnist put it. Anecdotal reports indicate that the experience is both time-consuming and frustrating; the best advice is to be patient, and to keep a paper-trail.

Option Adjustable Rate Mortgages (ARMs) were just one of many innovative financial products that rose to the fore during the housing bubble. They work by enabling borrowers to select from three options, the size of the payment they wish to make on their mortgage each month. The high payment is fully-amortizing (principal and interest), the middle payment is interest only, and the low payment is a token sum which does not even cover interest. That the bast majority such borrowers opted to make the low payment has led to the characterization of the Option ARM as the Negative Amortization ARM.

Many ARM borrowers actually caught a break after the housing bubble burst, since the consequent lowering of interest rates brought ARM rates down proportionately. Gushed one borrower, whose rate is tied to LIBOR, ““In 2009 I found out I have a 2.5 percent mortgage. That’s not onerous by any standards.” Unfortunately, lower interest rates doesn’t necessarily translate into lower payments.

There is a clause in most Option ARM contracts which states that if/when the loan reaches 60 months in age and/or the balance reaches a cap (110% – 125%), the loan automatically recasts. Essentially what this means is that the borrower must begin to make fully amortizing principal and interest payments; the minimum negative amortizing payment is no longer an option.

Due both to the decline in housing prices and the fact that most Option ARM borrowers elected to make the lowest payments, recasts are beginning to rise. 2011 meanwhile, will likely witness an explosion in recasts, as loans cross the 60-month time limit. According to a recent report by Fitch Ratings, this figure could be as high as 70%. Moreover, “Of the $189 billion securitized Option ARM loans outstanding, 88% have yet to experience a recast event. Of these loans that have not yet recast, 94% have utilized the minimum monthly payment to allow their loans to negatively amortize.”

For a significant portion of Option ARM borrowers, a recast is tantamount to a death sentence. Fitch predicts that ultimately, close to half of such borrowers could default on their mortgages. “They’re probably going to default at a rate that makes subprime look like a walk in the park,” warned one analyst. When you consider that as much as 14% of outstanding mortgages are Option ARMs and that most were used to purchase homes in bubble markets (California, Florida, Nevada, Arizona), the losses will probably be staggering.

Ironically, holders of Option ARMs don’t have many Options when it comes to mitigating the burdens posed by their mortgages. While refinancing could save money over the long-term, it would probably won’t help those who are currently struggling: “Just about anything they refinance into is going to give them higher payments than they have now,” explained one counselor.

Mortgage modifications, meanwhile, are also pretty much off the table, since they are intended to lower one’s mortgage rate rather than to lower one’s payment, directly. ” ‘The problem with these option ARM borrowers is they are already paying a low rate,’ [Barclays Analyst] Deb said, adding that a better solution would involve forgiving part of the loan balance, something that most lenders have been unwilling to do.” Still, if you’re facing such a predicament, it wouldn’t hurt to talk to your lender. As the problems surrounding Option ARMs become more prominent, lenders might become increasingly keen to play ball.

The Mortgage Calculator’s last report on the status of the federal government’s Home Affordable Modification Program (Banks Represent Main Obstacle to Loan Modification) argued that banks were largely to blame for the program’s failure to get off the ground. In an attempt to jump-start modifications, “The administration on Aug. 4 unveiled the first of what will be monthly name and shame exercises, publishing data on the loan-modification efforts of about three dozen companies.”

Three weeks later, however, it doesn’t look like much progress has been made. “Moody’s analyst Celia Chen…said that the number of modifications ‘will have to step up substantially in the remainder of this year in order’ to hit the 1.5 million to 2 million modifications that her firm estimates can be completed under HAMP by 2012,” which is less than half of the target of 4 million set by the government.

Demand for loan modifications is still running strong according to anecdotal evidence, which suggests that the fault lies primarily with the banks. According to government estimates, “Only 9 percent of eligible borrowers had been offered trial loan modifications through June.” By their own admission, banks remain reluctant to participate in the program. “In the Fed’s latest survey of senior loan officers, about 30 percent of banks said they were still tightening standards for both consumer and business loans.”

In some cases, banks have even acted counterproductive to the modification process, by dubiously suggesting that borrowers should deliberately fall behind on their payments in order to qualify for modification. It’s not clear whether such a strategy can ultimately be successful, but from a cost/benefit standpoint, it’s definitely not advisable. Horror stories abound, whereby “the modifications never came….These borrowers burned through retirement savings, destroyed their credit ratings and suffered mental and financial hardship,” and even foreclosure!

The government also deserves some of the blame for not making the program altogether transparent. One columnist seeking to navigate the process himself, wrote: “I discovered, just trying to access the program put me through a torturous weeks-long battle with red tape that made my previous interactions with the RMV and the IRS seem downright fun.” Unfortunately, his experience seems to be typical, and the relative handful of borrowers who were ultimately lucky enough to secure modifications were only able to do so after months of hard work and persistence.

The Mortgage Blog has reported at length on the government’s loan modification program, focusing mainly on its failures. This week, the government itself, confirmed this failure, by issuing a report card on the banks charged with carrying out the program. “The Treasury Department said on Tuesday that only a small number of homeowners — 235,247, or 9 percent of those eligible — had been helped…The assistant secretary for financial institutions, said in a news conference that there were ’significant variations’ in performance and that some institutions had made ‘an infinitesimally small amount’ of progress.

Bank of America and Wells Fargo received the worst grades, having modified only 4% and 6%, respectively, of eligible mortgages. Citigroup and JP Morgan, at 15% and 20%, were the two standouts, though some unnamed banks were reported to have achieved modification rates in excess of 25%. Disturbingly, “The first monthly progress report showed that 10 lenders had not changed a single mortgage.” To be fair, some banks have also modified loans that fall outside the scope of the government program, which don’t get includes as part of the official statistics; Wells Fargo, for example, modified 220,000 such loans.

Notwithstanding these exceptions, the report card indicates that the loan modification program has fallen well short of helping the majority of borrowers with distressed mortgages, of which the Treasury Department has identified nearly 3 million. Compare this to the”Obama administration’s original projections of up to 4 million loan modifications and 5 million refinanced loans. The report card, then represents an effort to shame the banks into compliance. Sure enough, Bank of America has declared, “Despite our aggressive efforts to find solutions for homeowners in default, we must improve our processes for reaching those in need.” Wells Fargo issued a similar promise.

The government has also moved to apply more direct pressure. “In an effort to get things moving, the government has summoned mortgage executives from 25 companies to meetings Tuesday with top staffers from the departments of Treasury and Housing and Urban Development,” reported one source. The result of this meeting was “a verbal agreement with the executives for a new goal of about 500,000 loan modifications by Nov. 1.” Unfortunately, the government has yet to release a new version of its plan – the now famous $50 Billion Hope for Homeowners Act. It seems unlikely that banks will receive additional compensation as part of the new plan, on top of the $4,500 per modified mortgage that they already receive. The government evidently is betting that bad PR and public outcry will be enough to bring about changes.

For those of you who haven’t yet been granted a modification, don’t give up! “Eligible loans are at least 60 days past due, in foreclosure or bankruptcy, and originated before 2009. The underlying property must be owner-occupied and conform to Fannie Mae and Freddie Mac loan limits, which can be as high as $729,750 in some areas.”

The Mortgage Calculator has blogged extensively on the topic of loan modifications, and many of the posts have harped on banks for failing to make the program a success. A couple of recent exposes in the mainstream media, lend additional credence to this notion. It turns out that despite the cash subsidies offered by the government, loan modifications are still less profitable for banks, on average, than the alternatives.

The first alternative is to take no action. Research has showed that a large portion of borrowers (between 1/5 and 1/3 according to two estimates) are able to catch up on their loan payments without help from the lender. Meanwhile, “A second set are those who are likely to fall behind on their payments again even after receiving a modified loan and are likely to lose their homes one way or another. Lenders don’t want to help these borrowers because waiting to foreclose can be costly.”

Another option is to allow the home to slide into foreclosure. Conventional wisdom suggests that foreclosure is never profitable for the bank. What this notion ignores, however, is that the majority of mortgages are packaged and bought by investors, leaving the bank only to service the loans. In such cases, the hit caused by foreclosure is born entirely by the investors, rather than by the originator. As a result, “Even when borrowers stop paying, mortgage companies that service the loans collect fees out of the proceeds when homes are ultimately sold in foreclosure. So the longer borrowers remain delinquent, the greater the opportunities for these mortgage companies to extract revenue — fees for insurance, appraisals, title searches and legal services.”

Then, there are the fees that lenders charge for late payments. “Servicers charge substantial penalty fees when loans are in delinquency or default — a source of revenue that goes away if a homeowner gets back on track.” That delinquent mortgages are extremely profitable is reinforced by the data: “From June 2008 to June 2009, the number of American mortgages that were 90 days or more delinquent soared from 1.8 million to nearly 3 million, according to the realty research company First American Core Logic. During that period, the number of loans that resulted in the bank taking ownership of the home declined to 245,000, from 333,000.”

Despite the federal government’s claim that the loan modification program has been and will continue to be a success, the fact remains that “The latest available figures show that the number of households at risk of foreclosure is 700% higher than the number of loan modifications, and the gap has been increasing steadily.” Until the program is tweaked, such that banks are compelled to increase loan modification volume – through greater incentives and/or stricter punishments – borrowers receiving loan modifications will remain the exception, rather than the rule.

According to a recent headline-grabbing study, “26% of the record numbers of home mortgage defaults across the country are ‘strategic‘ — that is, calculated economic decisions to bail out of loans by owners who actually have the money to make the payments but can’t handle the negative equity they’re carrying caused by local property value declines.” In most of the coverage to-date surrounding the foreclosure crisis, this class of defaulters has been largely ignored.

The study found that there were a few variable which correlate closely with borrowers’ respective willingness to intentionally default. First, and most obviously, is the value of the mortgage compared to the current value of the home. Specifically, those whose mortgages are most “underwater” are also most willing to default: “Researchers found that almost no homeowners would default if their equity shortfall was less than 10% of their home’s value, but one-in-six homeowners would default if their equity shortfall reached 50% of their home’s value.”

In controlling for age, location, and education level, the study determined that “Well-educated borrowers, homeowners in the Northeast and West, and people under 35 or over 65 were less likely to have moral reservations about choosing to walk away from making mortgage payments.” One’s sense of morality evidently plays a strong role in this calculation, with those who regarded strategic default is immoral 2-3 times less likely to default than their amoral counterparts. This relationship, however, is also proportionate to the size of one’s negative equity position: “While four out of five homeowners said they believed it was morally wrong to intentionally default, as negative equity rises, more borrowers—including those who said strategic defaults were immoral—would consider walking away.”

However, morality (in the case of strategic default at least) is apparently received from social cues. In other words, borrowers surrounded by default were themselves more likely to accept default as an amoral possibility. “The higher the number of foreclosures in a given ZIP Code, the higher owners’ willingness to walk away, the researchers found, suggesting what they call a ‘contagion effect that reduces the social stigma associated with default as defaults become more common.’ ”

This has some important implications for the recent federal legislation, which has aimed to prevent foreclosure by simply helping borrowers to modify their monthly payments, thereby making their mortgages more affordable. However, this legislation is built implicitly on the ideas that underwater borrowers will still repay their mortgages, and that affordability should be measured/enhanced on a monthly – rather than an aggregate – basis. If this report is to be believed, both of these assumptions are questionable. Perhaps this means that we will soon seen a corollary to this legislation passed, in which borrower equity (i.e. mortgage value) is also adjusted. Or maybe not.

Two of last weeks’ posts were entitled “Distressed Housing Attracts Speculators” and “How to Spot Mortgage Fraud.” While seemingly unrelated, these topics actually speak to two trends that are closely intertwined. The first trend is that the housing bust is increasingly starting to resemble the housing boom, from the standpoint of businesses that market themselves to homeowners. The second trend is a rise in mortgage fraud, again practiced primarily by mortgage service providers.

Essentially, many such companies have retooled (or closed and then re-opened under new names) and our now offering new services under the same pretenses. Specifically, many former subprime lenders are now in the business of modifying loans. This is especially repugnant considering that it’s partially because of these subprime lenders that unaffordable loans were issued in the first place, and now require modification if foreclosure is to be avoided.

A new investigative report by the New York Times (A must-read!) details exactly how one such company operated. “For fees reaching $3,495, with most of the money collected upfront, they promised to negotiate with lenders to lower payments on the now-delinquent mortgages they and their counterparts had sprinkled liberally across Southern California.” Backed by misleading national advertising campaign, the company was quickly flooded with calls by people desperate to avoid foreclosure.

Sales people quoted exaggerated success rates and in some cases encouraged borrowers to take money that would otherwise be used for mortgage payments and instead advance it to the loan modification company. According to one agent, “They basically told us, ‘Do whatever you need to do,’ ” he said. “ ‘It’s a sales floor. You’re here to sell.’ People would quote success rates and just pull them out of thin air. People would say 60 percent, 80 percent, 90 percent. To the average Joe in Kansas, that sounded great. But the reality is that 50 percent were immediately declined by the lender.” Customers were further sold on the pretense that their loan modification would be vetted and submitted by a licensed attorney, which was little more than a deliberate falsehood.

The company, FedMod, now faces a lawsuit by the Fair Trade Commission, which has also brought legal action against several similar companies. Still, given that thousands of people made payments to FedMod in good faith and now face foreclosure, it’s hard to argue that justice is being served. In the end, the most important lesson to take away from this debacle is never make an upfront payment for a loan modification. Never, ever, under any circumstances. Even if you are guaranteed a 100% success rat and that a licensed attorney will review your application. Never.

In fact, you can theoretically achieve a loan modification free or charge- either by speaking directly to your lender or with the help of an organization that is not-for-profit and/or government-approved. If you still feel compelled to enlist the services of a for-profit entity, at the very least you should hold off remitting payment until after your loan has been modified.

The recent stabilization of the housing market now appears to be a mirage, brought on by stopgap measures. “Until recently, many banks have put off launching foreclosure action on the troubled properties, in part because they had signed up for the Obama administration’s home-stability plan, which required them to consider the alternative of modifying loans to make it easier for borrowers to make payment. Unfortunately, the federal push to promote loan modifications and the related moratoriums that some states have imposed on foreclosures are already fading, at which point the foreclosure crisis is likely to expand.

“A new set of economic theorizing holds that any bottom that might have been glimpsed was a false one – just a plateau before a bigger drop, when lenders try to clear their books of bad loans. If that’s the case, the economic hole starts to look a lot deeper, and the housing crunch becomes another part of a larger, vicious cycle.” In other words, if banks move to place a fresh supply of foreclosed properties on the market, it will cause all prices to suffer. This will put even more pressure on those whose mortgages are already underwater (1 in 5, according to one estimate), and perhaps compel banks to race even faster to liquidate mortgages in default.

According to RealtyTrac, April “was the worst month ever, with more than 340,000 properties in some state of foreclosure nationally…They are expecting June’s numbers (to be released next week) to ‘give April a run for its money’ as worst month ever.” This was discerned from a large uptick in delinquent mortgages, many of which can be expect to result in foreclosures. “In the first quarter, some 1.8 million homeowners nationwide fell behind on their loans by 60 to 90 days, a 15% increase from the prior quarter, according to Moody’s Economy.com. The research firm said that loan defaults rose sharply as well, to 844,000 in the first three months of this year.”

Who’s to blame for this? The government appears to be doing as much as it can. “Foreclosure counseling is an extremely effective service; HUD reports that 45 percent of those who participated in 2008 were able to hang onto their homes.” While estimates vary, hundreds of thousands of borrowers have probably benefited from the loan modification program.

The problem is the banks, which continue to prefer foreclosure over loan modification. According to a new Federal Reserve paper, “lenders rarely renegotiate. Fewer than 3 percent of the seriously delinquent borrowers in our sample received a concessionary modification in the year following the first serious delinquency.”  There are two main reasons for banks’ entrenched resistance: “The first is ’self-cure risk,’ which refers to the situation in which a lender renegotiates with a delinquent borrower who does not need assistance…The second cost comes from borrowers who default again after receiving a loan modification. We refer to this group as ‘redefaulters,’ and our results show that a large fraction (between 30 and 45 percent) of borrowers who receive modifications, end up back in serious delinquency within six months.”

More on loan modification- and why it’s failing – tomorrow….