Helping Homeowners A Losing Proposition

November 14, 2008

Homeowners are losing their homes even when lenders could make more money by cutting a new mortgage deal, according to researchers at the Federal Reserve Board.

Why?

The middlemen between the borrowers and the lenders see working out deals with homeowners as a losing proposition. So, they haven’t bothered to add the specialized staff needed or change the way they handle delinquent loans, shortchanging everyone else.

These middlemen – called loan servicers – “do not have strong financial incentives” to invest in additional staff or technology required to contact borrowers and re-negotiate loans because investors won’t pay for much of the cost, according to the September 8, 2008 report, The Incentives of Mortgage Servicers: Myths and Realities.

See the Consumer Warning Network report in March 2008 describing how loan servicers turn a profit by foreclosing.

Servicers favor alternatives that are less labor intensive and less costly or which reimburse expenses, the report found. Investors are unwilling to reimburse the costs of loss mitigation, it said.

“Loan loss mitigation is labor intensive and thus raises servicing costs, which in turn make it more likely that a servicer would forego loss mitigation and pursue foreclosure even if the investor would be better off if foreclosure were avoided,” the report said.

In contrast, foreclosures and other parts of the loan default management process are more automated and do not require extensive contact with borrowers. Unlike loan workouts which increase labor and technology costs, foreclosures require few additional personnel. Investors reimburse loan servicers for other out-of-pocket costs, such as foreclosure fees and expenses.

“Loss mitigation costs are an added expense to servicers since a loan served a notice of default will continue through the normal foreclosure process even as loss mitigation is pursued,” the report added.

The type of loan workouts that keep people in their homes increased to about 300,000 per quarter last year. Loan modifications, which change the terms and conditions of the original loan, slightly exceed the number of loan workouts.

Under this “dual track” approach loan modifications and foreclosures proceed simultaneously. Researchers were told of cases where a house was repossessed within days of a feasible modification plan because the foreclosure tracked moved faster than the loss-mitigation track.

The report found:

  • The available evidence suggests that some avoidable foreclosures are being initiated because of inadequate loss-mitigation servicing capacity and various practices of servicers.
  • Given loss rates of 50 percent or more on subprime mortgages, both investors and borrowers could be better off with more effective loss mitigation.
  • The legal arrangements that govern loan servicing provide little guidance about how servicers should deal with delinquent loans, leaving the decisions up to the servicers. This lack of guidance appears to “dampen” loan workouts.
  • Loan servicers fear that they will be sued when interest rate changes or other loan modifications benefit one class of investors at the expense of another.
  • The holders of second mortgages and other “junior lien holders”  are “reluctant” to make changes without additional payments.
  • Citing the failure of loan workouts, investors fear that loan modifications will ultimately cost them more by delaying what ultimately will result in a foreclosure. Between 18 percent and 50 percent of subprime loan workouts failed within a few months.
  • Loan servicers see little gain from performing well because the prospects of gaining additional business in the subprime mortgage market in the future are dim.