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C. Re-Default Rates of Modified Loans-by Changes in Monthly Payments
Fourth Quarter 2008
As noted in last quarter's report, the reasons for high re-default rates are not clear. They could result from such factors as a significantly worsening economy with more borrowers losing jobs, excessive borrower leverage, issues affecting consumer willingness to pay, or poor initial underwriting. None of these factors can be easily captured in the type of data gathered by this report.
But another potential factor can be assessed more easily through data collection: the extent to which changes in monthly payments affect re-default rates. Loan modifications can reduce monthly payments, leave monthly payments unchanged, or increase monthly payments, depending on the circumstances.
Loan modifications may result in an increase in monthly payments where borrowers and servicers agree to add past due principal and interest, advances for taxes or insurance, and other fees to the balance of the loans and re-amortize the new balances over the remaining life of the loans. The interest rate on the loans may or may not be changed in these situations. Modifications may also result in an increased monthly payment for adjustable rate mortgages about to reset where the interest rate is increased but not by as much as contractually required. Servicers' modification activities also are dictated by private label and government agency servicing agreements which, in some cases, define the type and the amount of modification(s) that could be executed, and exclude modifications that reduce monthly payments. Servicers report, however, that recent changes in some government and private label servicing standards give them more flexibility to structure loan modifications that reduce monthly payments.
Modifications that result in a decrease in payments occur when banks elect to lower interest rates, extend the amortization period, or forgive or forbear principal.
Reduced payments make loan modifications more affordable, and it stands to reason that more affordable payments would be more sustainable and lead to lower re-default rates, whereas increased payments would lead to higher re-default rates. Data were collected for the first time in this quarter to determine whether loan modifications are more effective when loan payments are reduced. Modifications were grouped in four categories to reflect changes in monthly principal and interest payments, that is, modifications that (1) reduced monthly payments by more than 10 percent; (2) reduced monthly payments by 10 percent or less; (3) left monthly payments unchanged; and (4) increased monthly payments. Re-default rates were then calculated for each category.
To understand the data summarized below, two additional points are worth noting. First, while it may seem counterintuitive that a loan modification would increase monthly principal and interest payments-which seem to be at cross-purposes with the goal of producing a sustainable modification-there can be appropriate reasons for a servicer to take such an approach. For loans serviced for others, servicers are often contractually required to take those actions that maximize the value of the mortgage to the holder of the mortgage (the investor). Under normal economic conditions, servicers often modify delinquent mortgages-especially as a first step-by capitalizing missed payments, interest, advances for taxes or insurance, and fees, and then re-amortizing that amount over the remainder of a mortgage term. This practice may be appropriate in cases where borrowers experience temporary cash flow or liquidity problems but have prospects to repay debt over time. Under more positive economic conditions, this practice was generally accepted by investors, servicers, and lenders as an effective loss mitigation strategy. However, in periods of economic stress, the same strategy of increasing monthly payment can carry additional risk and should be administered on a case-by-case basis where borrowers' income is verified and servicers can have confidence that the modification is likely to be sustainable.
Also servicers' modification activities often are dictated by private label and government servicing agreements which, in some cases, define the type and the amount of modification(s) that could be executed. In this regard, a common type of loan modification that is allowed by these pooling and servicing agreements is the capitalization of missed principal and interest payments, fees, advances for taxes and insurance. Moreover, pooling and servicing agreements tended to target severely delinquent borrowers for modification rather than allowing servicers to work with borrowers who are either current or facing imminent default. Servicers report that recent changes in some government and private label servicing standards give them more flexibility to structure loan modifications that reduce monthly payments.
Second, the data summarized in this section of the report consistently show that re-default rates are higher for modifications that leave monthly payments unchanged than for modifications that increased monthly payments. The reasons for this apparent anomaly are unclear. According to servicers, one explanation for why loan modifications that result in unchanged payments would produce higher re-default rates is that modifications where the payments are unchanged generally do not involve a full assessment of the borrowers' capacity to continue their payments. Many of these modifications result from servicers freezing the interest rate on adjustable rate mortgages where borrowers face the risk of imminent default prior to the loans resetting to higher payments.