Loan Modifcations and Redeault Risk: An Examination o Short-Term Impacts
term. The ndings also show an even lower likelihood o redeault when the payment reductionis accompanied by a principal reduction. O course, not all loan modications that avoid redeaultare better or the lender. Further studies are still needed to compare the relative eectiveness o dierent types o loan modications based on a net present value analysis.This article proceeds as ollows. The next section reviews the current practices o loan modica-tions and the literature. The third section discusses the data and outlines the logistic models o theredeault behavior o borrowers with modied loans. The ourth section presents and discusses theresults, and the nal section concludes.
Loan modication has been regarded by the Obama Administration as one promising strategy tostem the food o home oreclosure, but not much solid research exists on this topic. In this sec-tion, we review some o the recent practices o loan modications and the literature on the eect o loss mitigation eorts.
Implementing Loan Modications
As o early 2007, most modications involved a capitalization o arrears or seriously delinquentloans and/or a principal orbearance, according to
Inside B&C Lending (2008). In 2007, however,interest rate resets on the massive 2005 and 2006 vintages were starting to cause deaults, becausethe rate indexes were high and monthly mortgage payments were rising by large amounts. Thedecline o housing prices started in late 2006 in many markets, making it dicult or borrowers torenance. In late 2007 and early 2008, the prereset modications (interest rate reeze or reduction)on subprime adjustable-rate mortgages (ARMs) increased signicantly. More recently, modica-tion activity has ocused on interest rate reductions and less seriously delinquent borrowers. Thecategory o principal reduction is still largely theoretical, however, and has not been used to anysignicant degree (White, 2008).The ederal government has relied primarily on encouraging lenders to voluntarily modiy theterms o existing mortgages. In October 2007, a coalition o mortgage servicers and housingcounseling agencies ormed the HOPE NOW Alliance to stimulate a voluntary eort to restructuremortgages. In June 2008, the HOPE NOW Alliance members issued guidelines or a streamlinedoreclosure prevention process or committed servicers. In August 2008, the FDIC, which tookover the ormer IndyMac Bank, launched the rst streamlined loan modication program orstruggling mortgage borrowers meeting certain criteria. This program is designed to help troubledborrowers achieve a sustainable 38-percent housing expense-to-income (HTI) ratio in the mortgageand decrease the borrower’s payment by 10 percent or more.
To reach aordable levels, mortgagemodications can combine interest rate reduction, extended amortization, and partial principal
I the initial modication at 38 percent o HTI does not decrease the borrower’s payment by 10 percent or more, theHTI ratio can be lowered to 35 percent and then to 31 percent to achieve the 10-percent savings. For cases in which a10-percent reduction cannot be achieved, the 31-percent HTI ratio is used or aordability. FDIC (2008) provides thetechnical details about the loan modication program.