Obama to test home loan do-overs
Foreclosure prevention effort starting Wednesday relies on modifying loans based on borrowers' ability to pay. Will this effort work where others have failed?
NEW YORK (CNNMoney.com) -- Mortgage modifications have a bad rap, yet President Obama is depending on them to stop the foreclosure crisis.
Modifications continue to be pushed as the best way to get struggling borrowers back on their feet. The jury is out on whether modifications work long-term. One recent study showed about half of borrowers with modified loans fell behind within six months.
Still, Obama is giving modifications a central role in his $75 billion foreclosure prevention program.
The program, which starts on Wednesday, calls for loan servicers to lower struggling borrowers' interest rates so that total payments are no more than 31% of their gross income. The government will subsidize part of the reduction, as well as kick in incentives for the servicers, borrowers and mortgage investors to participate in the modifications. (See "Do you qualify?")
The program is getting mixed reviews.
Industry experts applaud the president's emphasis on making payments affordable, a criteria made popular last year by Federal Deposit Insurance Corp. chief Sheila Bair. But, they say, the plan will fall short without a stronger push to reduce loan balances for those who owe more than their homes are worth and without a better plan for those deep in all kinds of debt.
Servicers are increasingly turning to modifications as the foreclosure crisis escalates. They have modified about 1.3 million loans between July 2007 and January 2009, according to statistics released Tuesday by Hope Now, an alliance of the mortgage industry and housing counselors. The efforts - which usually involve adjusting interest rates, loan length or principal balance - have been largely voluntary and uncoordinated.
In recent months, modifications have come under attack as a mere short-term fix. In December, the Office of the Comptroller of the Currency added fuel to that fire by reporting that more than half of borrowers with loans adjusted in the first half of 2008 were behind in their payments six months later. The Hope Now survey shows that between 30% and 40% of modifications had re-defaulted within six months.
But many modification supporters said reports of redefaults don't take into account how loans were modified. Until recently, the adjustments often entailed increasing the monthly payments to make up for the arrears.
Some 34% of mortgages modified in November resulted in a higher payment, while another 17% had no change in payment, said Alan White, a law professor at Valparaiso University. More than nine of 10 voluntary modifications in 2008 involved no cancellation of principal, past-due interest, late fees or expenses.
"The redefault problem has resulted in criticism of the very idea of modifying mortgage loans," White wrote in a January report. "On the other hand, there is considerable evidence that more aggressive modifications, especially those that reduce the principal debt, are much less subject to high rates of redefault."
In recent months, however, more servicers have focused on adjusting borrowers' payments to an affordable level, usually between 31% and 38% of a borrower's gross monthly income. Housing advocates, as well as industry officials, hope this will increase modifications' success rate.
"Affordability makes sense," said Faith Schwartz, Hope Now's executive director. "It's certain a key factor in why modifications will work even better."
It's too early to tell how well this new breed of modifications will perform. But an October Credit Suisse study showed that only 15% of interest-rate modifications and 23% of principal-reduction modifications made at the end of 2007 were delinquent eight months later, compared to 44% of adjustments that resulted in higher payments.
"Lots of modifications have not been done with a rigorous ability-to-pay criteria. As evidence of that, we see the high redefault rates," said Rod Dubitsky, head of asset-backed securities research at Credit Suisse. "Modifications that more carefully consider ability to pay should have a lower redefault rate."
Advocates also take heart in the relative success rate of servicers who have long focused on affordability. Take Ocwen Financial Corp. The servicer boasts of a 19.4% redefault rate, less than half the industry average.
The West Palm Beach, Fla.-based firm says most of its borrowers remain current because of its customized approach to modifications. Ocwen looks at borrowers' income and expenses and comes up with a payment plan that the homeowner can afford long-term. The company says it has prevented more than 90,000 foreclosures since the mortgage crisis began.
"If loan modifications are to have an enduring impact, the reduced mortgage payments must be sustainable by homeowners," Ocwen Chief Executive William Erbey said in a hearing before Congress a week ago.
Unlike most servicers, Ocwen has embraced principal reductions. Nearly 19% of its loan modifications include writing down the mortgage balance. This is an important step to achieving an affordable payment while still maximizing the payout for the mortgage investor, the company says.
Obama's plan has come under fire for not doing more to encourage servicers to reduce loan balances, a step which would help borrowers who have seen their home values plummet. The program does allow servicers to reduce principal, but makes interest rate adjustments the primary method for achieving affordable payments.
One in six homeowners are "underwater," meaning they owe more on their mortgage than the house is worth, according to Zillow.com. Though experts are divided in their opinion, many say that the foreclosure crisis won't be stemmed until something is done to help these borrowers - namely, principal reductions to bring the loan balance in line with the home's current value.
"Equity in the home is a significant driver of default," Dubitsky said.
Also, many borrowers are drowning in many types of debt, experts said. So just adjusting their first mortgage, or lien, is not enough. Ocwen, for instance, takes into account all of a borrower's obligations when calculating an affordable monthly payment.
Debt loads beyond the mortgage are a big factor in a borrower's ability to keep up with payments, Schwartz said.