Why Banks Won't Modify Your Mortgage: It Doesn't Pay

(MoneyWatch)  Federal initiatives such as the Making Home Affordable program aim to help homeowners keep their property by encouraging banks to renegotiate their mortgages. It isn't working. Lenders modified loans for less than three percent of delinquent borrowers within a year of their falling behind on payments, according to a new study by the Federal Reserve Bank of Boston.

But the report, which analyzed more than 29 million residential mortgages, also explains why lenders are reluctant to modify mortgages: It doesn't pay. Banks, mortgage servicers and investors make more money from foreclosing on a home than from, say, cutting the interest rate on the loan or adjusting the principal balance. Not that lenders profit from foreclosures -- they typically recover less than half the principal owed on a mortgage -- but they recoup more of their dough than by modifying loans.

Testifying last week before the Senate Committee on Banking, Housing, & Urban A?€airs, report author and economist Paul Willens said banks are deterred by two major risks:

The ??rst, which has been recognized as an issue by many observers and researchers, is "redefault risk" - the possibility that the borrower who receives a modi??cation will default again, and thus the modi??cation will have only served to postpone foreclosure and increase the loss to the investor as house prices fall and the home itself (the collateral) quite possibly deteriorates. The second risk, which has been largely ignored but I believe is no less important, and arguably more, is "self-cure risk" - the possibility that the borrower would have repaid the loan without any assistance from the lender.... An investor would view assistance given to such a borrower as "wasted" money.

This has important implications not only for the Making Home Affordable program, but for the whole of public policy implemented since 2007 to stem foreclosures, including the Treasury Department's HopeNow plan and the Hope for Homeowners act, which Congress passed last year. None of these solutions has worked. To date, only 20,000 loans have been refinanced under Obama's mortgage modification initiative, according to the Treasury. Lawmakers had expected millions of homeowners to capitalize on the program. And now we know why such efforts have failed. Each was predicated on a faulty assumption -- that it is in lenders' financial interest to help homeowners refinance their mortgages.

Here's what I expect to happen next. With foreclosure rates going through the roof, Congress has no choice but to give another pass at reforming the nation's mortgage bankruptcy laws. A so-called cram-down bill, championed by Sen. Dick Durbin, D., Ill., that would've let bankruptcy courts alter mortgages ran aground this spring. Even some fellow Democrats opposed the measure, suggesting that financial industry lobbyists had persuaded lawmakers to give Obama's loan modification plan a chance before administering stronger medicine.

But the disease is progressing, and Capitol Hill knows it. A Senate Judiciary administrative oversight subcommittee hearing on the foreclosure crisis this Thursday (accessible by Webcast) could shed light on how aggressively Senate Democrats push the issue.