75% of modified home loans will redefault

NEW YORK (CNNMoney.com) -- Most borrowers who have had their mortgages modified through a government-sponsored program will redefault within 12 months, according to a report released Wednesday.

Between 65% and 75% of loans that are modified through the Home Affordable Modification Program but not backed by the federal government are likely to go bad, according to the report released by Fitch Ratings, a N.Y.-based credit-rating agency.

The main reason these borrowers continue to struggle is that HAMP does nothing to solve the rest of their debt problems, the report added.

"Many of these borrowers still have very heavy levels of other debt," said Diane Pendley, a Fitch managing director, "auto loans, credit cards and other expenses. The HAMP modifications reduce housing expenses down to 31% of income but do not touch these other obligations."

On average, HAMP-modified borrowers, according to Pendley, have 64% of their monthly pretax income spent before they even buy a quart of milk. If even a small emergency arises -- an unexpected car repair, a medical bill or a loss of overtime income -- they're in trouble.

"We're talking borrowers who don't have cash reserves," said Pendley. "If they did, they wouldn't be in this position in the first place. It doesn't take much for them to get in the same situation again"

Jay Brinkmann, the chief economist for the Mortgage Bankers Association, finds nothing at all surprising about the Fitch finding. "Over the course of studying this over several years," he said, "we find re-default rates from 40% to 60% on modified mortgages. You have borrower behavior that keeps coming back."

When that happens, lenders are much more likely now to recommend that borrowers opt for foreclosure alternatives instead of modifying loans a second time.

Currently, according to the Fitch report, about half of prime borrowers who lose their homes now do so through foreclosure.

The other 50% go through short sales, in which they sell their homes for less than what they owe the bank, or deed-in-lieu, a transaction where the bank takes back the property directly and forgives the outstanding balance.

The servicers have been encouraged to rev up their short sale engines by the Treasury Department, which runs HAMP and its sister program, Home Affordable Foreclosure Alternatives (HAFA), which provides cash incentives to the parties who agree to short sales..

Now, when borrowers re-default on HAMP mods or other bank workouts, banks are much more likely to offer help to execute a short sale or deed-in-lieu.

"HAFA gave the servicers an indication that this is where they should take these [re-defaulting loans]," said Pendley. "The banks are now assisting borrowers; they're being much more proactive, like helping them find real estate brokers for short sales."

The benefit of these transactions for borrowers is that it lets them move on more quickly with their lives. They can get out from under the unaffordable mortgage payments, find a cheaper rental, start to, perhaps, save a little cash and start to rebuild their credit scores.