Less than one in 50 mortgage modifications includes debt forgiveness, which is considered the surest way to prevent foreclosure.

For every troubled homeowner whose mortgage principal is reduced in a modification, 39 others end up with more housing debt as lenders tack on missed payments, late charges and even attorney fees to the loan balance.

Lenders are reluctant to reduce principal on delinquent mortgages, and the Obama administration’s Home Affordable Modification plan, or HAMP, doesn’t force them to. That needs to change, consumer advocates say.

“Ultimately, we believe in order to be effective, HAMP may need to mandate principal reductions,” Diane Thompson, counsel for the National Consumer Law Center, told the Senate Banking Committee July 16. “With one out of five homeowners underwater, significant readjustments in principal balances are necessary for the economic stability of the country.”

No one expects lenders to forgive mortgage debt as eagerly as they granted it to unqualified borrowers, so it probably would take political pressure to make them do it. Such pressure doesn’t seem forthcoming.

In a recent letter, the secretaries of Housing and of the Treasury ordered mortgage servicers to hire more people to process modifications, mail more letters to borrowers and appoint high-level liaisons to federal regulators. There was no mention of which types of modifications the servicers should offer.

Debt forgiveness equals success

A number of researchers have found that the most successful mortgage modifications involve debt forgiveness. Yet, according to the Comptroller of the Currency and the Office of Thrift Supervision, just 1.8 percent of modifications in the first quarter of 2009 forgave debt. That’s about one in 50 modifications.

The other 49 modifications consisted of rate reductions or rate freezes, term extensions and “capitalization,” which means that the missed payments and fees were added to the homeowner’s debt burden. Some 70.2 percent of modifications included capitalization: That means that for every troubled borrower who got debt forgiveness, 39 ended up owing more.

Loan performance, six months after modification in 2008
Payment decreased 20% or more Payment decreased 10% to 20% Payment decreased less than 10% Payment unchanged Payment increased
Percentage 90 or more days delinquent 15.6 19 24.2 45.7 37.9
OCC-OTS Mortgage Metrics Report, 1st Quarter 2009

The average amount added to mortgage balances: $10,800, according to Alan White, assistant professor of law for Valparaiso Law School, in his study published in January, of 3.5 million privately securitized mortgages.

“It is apparent now that mortgage modifications will succeed in achieving sustainable repayment, and in reducing the aggregate debt overhang, only if they include reductions of principal to align debt with property values,” White writes.

What prevents foreclosures?

White and other researchers have focused on the issue of what kinds of modifications result in fewer foreclosures. There are other issues, too: Is it fair to forgive the debt of feckless borrowers? How does a servicer figure out whether the optimal financial outcome is foreclosure or modification? But one thing is clear: Debt forgiveness is effective at preventing foreclosure.

There’s an obvious reason and a not-as-obvious reason that principal reductions result in fewer foreclosures. The obvious reason is that less debt equals a smaller monthly payment. People get modifications because they have trouble making their mortgage payments, so smaller payments tend to help.

In their quarterly mortgage metrics reports, the Comptroller and OTS don’t track the success of mortgages involving debt forgiveness. But they do track the success rate depending on whether the monthly payment was increased, stayed the same or decreased by a little or by a lot. It turns out that six months after modification the loan is twice as likely to be 90 days past due if the payment was increased than if the payment was decreased by 10 percent or more.

The less-obvious reason that debt forgiveness is effective: Homeowners are more likely to let foreclosure proceed if they owe more than the house is currently worth. If a lender forgives enough debt to eliminate negative equity, the borrower is less likely to default.

“More simply put, loan to value has always been the most powerful predictor of default, and borrowers whose home is worth less than what they owe are more likely to default, either in a ‘ruthless’ manner, or because they cannot afford to sell the house if they need to,” write a trio of researchers from the University of North Carolina in a March working paper about loan modifications. Their study scrutinized more than 1 million nonprime mortgages originated in 2005 and 2006, the peak years of risky lending.

The researchers — Lei Ding, Roberto Quercia and Janneke Ratcliffe — concluded that modifications were more effective when monthly payments were lowered, and that principal reduction worked best.

Ratcliffe says she’s not campaigning for everyone to get debt forgiveness. “Modifications need to be adapted to individual situations to be effective,” she says. “There’s a lot of things you can do — term extensions and principal reductions and rate reductions. You know, I can do principal reductions for everybody — it would be silly to do it for people who have equity in their house. And some loans are so far underwater that you can’t.”

Even some mortgage investors — the people and institutions that own loan pools — make the case for debt forgiveness. Curtis Glovier, representing the Mortgage Investors Coalition, whose members collectively own $100 billion in mortgage-backed securities, told the Senate Banking Committee this month that his group favors principal reductions in some cases.

“The best solution to our nation’s mortgage crisis is to significantly forgive principal on first- and second-lien mortgage debt in connection with the refinancing of the overextended homeowner into a new, low interest rate mortgage through the Hope for Homeowners program,” Glovier said.

Flop for homeowners

Hope for Homeowners, or H4H, was launched last fall. It called for lenders to forgive some mortgage debt and allow loans to be refinanced into FHA-insured mortgages. The initiative flopped: In seven months, only one borrower got an H4H refi, because the requirements were so restrictive. Congress loosened up the program in May, and it’s too early to gauge the renewed H4H’s success.

Hardly anyone in the mortgage industry talks about H4H, under the assumption that it will fail again. That leaves the Home Affordable Modification program as the last plan standing. Almost five months after the feds released the HAMP guidelines, mortgage servicers are still trying to put the procedures in place while hiring and training thousands of employees.

It’s an uphill climb because mortgage servicers were unequipped to deal with large numbers of modifications. Third-party companies have offered their expertise. One such company is Response Analytics, whose CEO, Brent Lippman, marveled this spring at how primitive the mortgage servicing companies were.

“What amazes me is how unsophisticated this whole space is, how weak they are in the analytics, and how much help they could use,” Lippman said in March, shortly after the Obama administration unveiled HAMP. “There’s going to be a lot of scrambling and mistakes for the first six months or more.”

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