The second in a series of three articles

Testimony of Paul Leonard
California Office Director
Center for Responsible Lending

Loan modifications offer the most promising alternative for borrowers, taxpayers and the healthy functioning of mortgage markets in the future. They can provide long-term affordability to borrowers while avoiding much more expensive foreclosures for lenders. And even lending industry leaders have acknowledged that many of these borrowers qualified for sustainable, 30-year fixed rate subprime mortgages, typically at a cost of only 50 to 80 basis points above the introductory rate on the unsustainable exploding ARM they were provided. [See January 25, 2007 letter from the Coalition for Fair & Affordable Lending (CFAL), an industry association, to the heads of the federal banking regulators, urging the regulators not to apply the October 4, 2006 Interagency Guidance on Nontraditional Mortgage Product Risks to subprime 2-28 ARM loans.]

In fact, a review of a broad array of lender rate sheets establishes that those borrowers who were given “no doc” loans notwithstanding their ability to document their income could have received 30-year fixed rate fully documented loans at a lower rate than the no-doc 2/28 adjustable-rate mortgages they received. [As recently as July 2007, even as the debacle was unfolding, that remained the case. For example, a borrower with a 620 FICO score, 90% LTV, and 1 –30 day delinquency, could get a 30-year fixed rate mortgage at 10.25% from Option One, compared to 11.9% for a 3/27 stated doc loan. At WaMu’s Long Beach Mortgage, that borrower could get a 10.1% 30-year fixed rate loan, compared to a 10.95% 2/28 Stated income loan.] And this does not include the 20% or so of subprime borrowers who qualified for conventional loans from the beginning.

For most types of subprime loans, African-Americans and Latino borrowers are more likely to be given a higher-cost loan even after controlling for legitimate risk factors. Debbie Gruenstein Bocian, Keith S. Ernst and Wei Li, Unfair Lending: The Effect of Race and Ethnicity on the Price of Subprime Mortgages, Center for Responsible Lending, (May 31, 2006). See also Darryl E. Getter, Consumer Credit Risk and Pricing, Journal of Consumer Affairs (June 22, 2006); Mike Hudson & E. Scott Reckard, More Homeowners with Good Credit Getting Stuck with Higher-Rate Loans, Los Angeles Times p.A-1 (October 24, 2005); Howard Lax, Michael Manti, Paul Raca, Peter Zorn, Subprime Lending: An Investigation of Economic Efficiency, 533, 562, 569, Housing Policy Debate 15(3) (2004).

For borrowers, loan modifications provide the best opportunity to avoid the loss of their homes – ideally with long-term affordable mortgages. The best modifications, as recommended by the FDIC, will convert the existing adjustable rate mortgage to a long-term fixed rate mortgage at the original introductory interest rate for the life of the loan. Given that these initial rates were already risk-adjusted and substantially exceeded prime rates, any alleged “risk” from modifying these loans into sustainable products is mitigated.

This type of adjustment should be sufficient to achieve affordability for borrowers in markets such as California that have not yet experienced significant price declines.

For borrowers in markets with steep price declines, deeper modifications may be necessary. For these borrowers, it still may be economically prudent for servicers to reduce the interest rate or the loan balance, rather than face the even higher costs of foreclosures.

For taxpayers, modifications minimize the negative consequences of foreclosures and prevent the need for large infusions of taxpayer subsidies to avoid them. Specifically, concentrated foreclosures serve to depress the prices of nearby homes, and to reduce the tax income to state and local governments. Concentrated foreclosures can also lead to higher municipal costs, as local governments step in to maintain the security and appearance of vacant homes in their communities. [Erik Eckholm, “Foreclosures force suburbs to flight blight,” The New York Times. March 23, 2007.]

For mortgage markets, modifications refocus market incentives on sustainable loans, a healthy market and sustainable homeownership. Modifications will ensure that losses are borne by the lenders and investors who are responsible for making loans without adequately evaluating the borrower’s ability to repay them. This should lead lenders to make sustainable loans and servicers to properly service their portfolios. As long as any losses resulting from the loan modifications (relative to the original loan terms) are less than the losses that would result from a foreclosure, implementation of modifications is consistent with the servicers’ requirements to maximize cash flows for the investors in securities as a whole.

Despite Lender Rhetoric, Modifications to Date Have Been Limited

For months now, many large servicers have been trumpeting their efforts to contact borrowers facing resets early and to offer aggressive loan modifications. To date, however, the reality of results has not matched the rhetoric. According to a recent survey by Moody’s, less than one percent of borrowers with subprime ARMs were receiving loan modifications at the time when their mortgage payments reset. [Jeanne Sahadi, CNN Money. “Subprime: Big talk, little help.” September 26, 2007. ] The housing counselors, community groups and consumer lawyers we hear from tell us that, in the vast majority of cases, modifications are not happening. [See, e.g., Carolyn Said, “Modified mortgages: Lenders talking, then balking,” San Francisco Chronicle, September 13, 2007.] Additionally, California Reinvestment Coalition recently surveyed 33 of the states’ 80 housing counseling agencies and reported that few long-term affordable modifications were being offered. [The Chasm Between Words and Deeds: Lenders Not Modifying Loans as They Say To Avoid Foreclosures. California Reinvestment Coalition, October 2007.]

We also are hearing that even in the minority of cases where modifications are offered, they are limited to a one-year or even a six-month extension of the introductory interest rate, a modification that is too short-term to allow a family to engage in meaningful planning for their financing, housing and children’s schooling. Any sustainable, meaningful loan modifications would ideally last for the life of the loan, but certainly no shorter than five years.

A related and critical concern is that different borrowers will be treated differently (for example, those who cannot afford legal representation may be at a distinct disadvantage and may not be offered the same, or any, options). One need is to standardize the loan modification process to ensure fairness and efficiency.

There are a number of potential reasons to explain the failure to provide modifications despite their basic economic appeal. These include:

Misaligned financial incentives: It appears that despite the larger economic savings from modifications, servicers may get paid more for a foreclosure than for doing a loan modification. A Deutsche Bank Securities official recently was quoted: “Servicers are generally dis-incented [sic] to do loan modifications because they don’t get paid for them, but they do get paid for foreclosures.” This official went on to indicate that it costs servicers between $750 and $1,000 to complete a loan modification. [Quote from Karen Weaver, managing director and global head of securitization research at Deutsche Bank Securities. “Subprime Debt Outstanding Falls, Servicers Pushed on Loan Mods,” Inside B&C Lending, November 16, 2007 p. 3. ]

• This theory has been bolstered recently, as John Reich, head of OTS, has called for $500 payments to servicers for each loan modification.

• Servicers are overwhelmed. The magnitude of the crisis has simply been too much for many servicing operations to respond effectively at the individual level, even when managers support modifications. Hundreds of thousands of borrowers are asking for relief from organizations that have traditionally had a collections mentality, have been increasingly automated, and whose workers are simply not equipped to handle case-by-case negotiations.

• Fear of investor lawsuits. The servicer has obligations to the investors who have purchased the mortgage-backed securities through pooling and servicing contracts, but there are conflicting interests among the different levels of investors. Servicers are hesitant to modify the loans because they are concerned that it will impact different tranches of the security differently, and thereby raise the risk of investor lawsuits when one or more tranche inevitably loses income. This phenomenon is known as “tranche warfare.” For example, a modification that defers loss will favor the residual holder if the excess yield account is released, but will hurt senior bondholders. Servicers see foreclosure as the safest course legally.

Piggyback seconds. The most intractable problem is the fact that one-third to one half of 2006 subprime borrowers took out piggyback second mortgages on their home at the same time as they took out their first mortgage. [Credit Suisse, Mortgage Liquidity du Jour: Underestimated No More, March 12, 2007, p. 5.]

• In these cases, the holder of the first mortgage has no incentive to provide modifications that would free up borrower resources to make payments on the second mortgage. At the same time, the holder of the second mortgage has no incentive to support an effective modification, which would likely cause it to face a 100% loss. The holder of the second is better off waiting to see if a borrower can make a few payments before foreclosure. Beyond the inherent economic conflict, dealing with two servicers is a negotiating challenge that most borrowers cannot surmount.

The first article in this series is The Subprime Mortgage Crisis: California at the Epicenter of National Foreclosures.