by Bill McBride on 7/11/2009 07:24:00 PM
Saturday, July 11, 2009
From Manuel Adelino, Kristopher Gerardi, and Paul S. Willen writing at the Boston Fed: Why Don’t Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures, and Securitization
(ht Holden Lewis, Mortgage Matters at Bankrate.com)
One of the key questions these researchers ask is: Why don't lenders renegotiate1 with delinquent borrowers more often?
If a lender makes a concession to a borrower by, for example, reducing the principal balance on the loan, it can prevent a foreclosure. This is clearly a good outcome for the borrower, and possibly good for society as well. But the key to the appeal of renegotiation is the belief that it can also benefit the lender, as the lender loses money only if the reduction in the value of the loan exceeds the loss the lender would sustain in a foreclosure.Just last week, Gretchen Morgenson at the NY Times made this argument: So Many Foreclosures, So Little Logic
all emphasis added
[T]he most fascinating, and frightening, figures in the [subprime loan] data detail how much money is lost when foreclosed homes are sold. In June, the data show almost 32,000 liquidation sales; the average loss on those was 64.7 percent of the original loan balance.And the Fed economists respond:
Here are the numbers: the average loan balance began at almost $223,000. But in the liquidation sale, the property sold for $144,000 less, on average. ...
Given losses like these, [Alan M. White, an assistant professor at the Valparaiso University law school in Indiana] said he was perplexed that lenders and their representatives were resisting reducing principal when they modify loans. His data shows how rare it is for lenders to reduce principal. In June, for example, 3,135 loans — just 17.2 percent of the total modified — involved write-downs of principal, interest or fees. The total loss from these write-downs was just $45 million in June.
And yet, the losses incurred in foreclosure sales involving loans in the securitization trusts were a staggering $4.59 billion in June. “There is 100 times as much money lost in foreclosure sales as there was in writing down balances in modifications,” Mr. White said. “That is not rational economic behavior.”
If banks have written down the value of these loans to the 40 cents on the dollar that they are fetching on foreclosures — the only true value for these homes right now — then why don’t they bite the bullet and reduce the loan amount outstanding for the troubled borrowers?
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 [30 and 45 percent]; 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.I'd argue for a third reason: If it became widely known that lenders routinely reduce the principal balance for delinquent borrowers with negative equity, this would be an incentive for a large number of additional homeowners to stop paying their mortgages.
These economists would argue that the lenders are behaving rationally and that foreclosure - when all costs are considered - is frequently the least costly alternative.
1 The economists define “renegotiation” as "concessionary modifications that serve to reduce a borrower’s monthly payment. These may be reductions in the principal balance or interest rate, extensions of the term, or combinations of all three." Under this definition, they do not include the most common modification: capitalization of late payments and fees.