The Federal Reserve Bank of Boston has a new study out that, if true, throws a serious wrench into the Obama administration’s plan for preventing foreclosures. The Obama plan hinges on the notion that it is more expensive for a lender to put a homeowner through foreclosure than to modify that homeowner’s loan. However, the Boston Fed found that this may not be the case:
[W]hat is the explanation for why lenders do not renegotiate with delinquent borrowers more often? We argue for a very mundane explanation: lenders expect to recover more from foreclosure than from a modified loan. This may seem surprising, given the large losses lenders typically incur in foreclosure, which include both the difference between the value of the loan and the collateral, and the substantial legal expenses associated with the conveyance. The problem is that renegotiation exposes lenders to two types of risks that can dramatically increase its cost.
The banks supposedly think that borrowers will either redefault on their modified loan or fix their financial problems all by themselves, either of which would make a modification not worth it. Now, the Boston Fed only looked at subprime loans, so applying its findings to current foreclosures (which are increasingly in prime loans) isn’t exact. However, it’s undeniable that the loan modification effort has been slow in getting off the ground, and right now, there’s nothing in the administration’s housing plan that incentivizes lenders to make more modifications.
Cram-downs (which would have enabled bankruptcy judges to write down mortgage payments) were once meant to be that incentive. But that provision met its end in the Senate, thanks to an intense lobbying effort on the part of the banks.
As Tim Fernholz reported, Treasury doesn’t seem interested in changing the modification program just yet, but if the number of foreclosures keeps rising and banks keep refusing to quicken the pace of modifications, its hand might be forced. So what other stick can be implemented to encourage lenders to modify loans? Center for Economic and Policy Research co-director Dean Baker has been advocating for giving foreclosed-upon homeowners the right to rent their homes at market value for a specified period of time:
This “right to rent” proposal would immediately give homeowners security in their home, so that if they liked the home, the schools, and the neighborhood, they would have the option to stay there for a substantial period of time. This temporary change in foreclosure rules would also give lenders a strong incentive to renegotiate mortgage terms to allow homeowners to stay in their homes as owners, since few lenders will want to become landlords.
As the recession continues, more and more borrowers are going to find themselves facing foreclosure, and it’s imperative that the administration find a way to prevent as many as it can.