Mortgage Loan Modification: Promises and Pitfalls

Abstract:     
Servicing is costly, and increasing loan modifications increases the costs of servicing. While the practice of modifying loans shows promise, the practice is highly risky, both to the consumer and the lender, and substantially unproven. Moreover, there are currently no industry standards for modification and financial reporting, and no consumer safeguards to monitor or prohibit predatory practices. Modification will not be suited to helping avoid the massive defaults expected as a result of ARM interest rate resets, which account for the majority of the industries problems into 2008. Legislative pushes to mis-apply the practice to those ends will substantially worsen industry performance. One of the key reasons loan modification has grown has been to skew financial reporting of delinquencies, modifying loans to help borrowers make a few payments and then aggressively reaging the accounts to classify them as "current," instead of "delinquent." Regulators can already require modified loans to be reported as material considerations under Sarbanes-Oxley with standardized reporting practices promulgated by the Financial Accounting Standards Board and Regulation AB. It does not make sense, therefore, to push a broad unmonitored application of loan modification onto the industry or the public without serious consideration. Doing so runs a substantial risk of consumers being used to prop up the mortgage industry in the short term by keeping financially-strapped consumers in homes they cannot hope to afford. It does make sense, however, to apply limited modification programs to appropriately-selected consumers while helping to smooth the transition to smaller homes or rentals for others.

Keywords: subprime mortgage, servicing, modification, mitigation, mortgage crisis

JEL Classifications: G18,G21, G28

Working Paper Series