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Loan Modifications and Re-Default Risk

Loan Modifications and Re-Default Risk

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Published by Martin Andelman
A paper written by:
Roberto G. Quercia, University of North Carolina at Chapel Hill
Lei Ding, Wayne State University
Cityscape: A Journal of Policy Development and Research, Volume 11, Number 3, 2009
U.S. Department of Housing and Urban Development, Office of Policy Development and Research
A paper written by:
Roberto G. Quercia, University of North Carolina at Chapel Hill
Lei Ding, Wayne State University
Cityscape: A Journal of Policy Development and Research, Volume 11, Number 3, 2009
U.S. Department of Housing and Urban Development, Office of Policy Development and Research

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171
Cityscape: A Journal of Policy Development and Research
• Volume 11, Number 3 • 2009
U.S. Department of Housing and Urban Development • Ofce of Policy Development and Research
Cityscape
Loan Modications and
Redefault Risk:An Examination ofShort-Term Impacts
Roberto G. Quercia
The University o North Carolina at Chapel Hill
Lei Ding
 Wayne State University
Abstract
One promising strategy to stem the ood of home foreclosures is to modify mortgageloans so that borrowers can remain in their homes. A primary concern of loan modicationefforts, however, is the seemingly high rate of recidivism. In this article, we examinethe relationship between redefault rates and different types of loan modications basedon a large sample of recently modied loans. Our ndings show that the key componentto making modied loans more sustainable, at least in the short run, is that mortgage payments are reduced enough to be truly affordable to the borrowers. The ndingsalso show an even lower likelihood of redefault when the payment reduction is theresult of a principal reduction. Unfortunately, our ndings also show that to reduceredefault for modied loans that are currently under water (those with signicantnegative equity), more signicant loan restructuring or renancing may be needed.
Introduction
The oreclosure crisis shows no sign o abating. More than 2.3 million homeowners aced oreclo-sure in 2008, an 81-percent increase rom 2007 (Aversa and Zibel, 2009). The oreclosure crisisand the resulting credit and nancial turmoil became a ull-fedged national and global recessionin late 2008. Payroll employment has declined by 3.6 million since December 2007 and more thanone-hal o this decline occurred between November 2008 and February 2009 (Bureau o LaborStatistics, 2009). Job losses lead to more oreclosures, which, when added to the already oversuppliedreal estate market, urther reduce home values, leading to even more oreclosures. The $2.8 trillion
 
172
Quercia and Ding
Refereed Papers
nancial loss in household real estate wealth rom 2006 to the third quarter o 2008 urther weakensthe overall economy, leading to more income loss (Board o Governors o the Federal ReserveSystem, 2008).Borrowers’ inability to meet mortgage payments is the core o the oreclosure problem, and a modi-cation o the terms o mortgages has been regarded as a means to reduce the payment burden. Byproviding troubled homeowners with relie, modications can be regarded as a tool or oreclosureavoidance. For instance, under the Federal Deposit Insurance Corporation’s (FDIC’s) streamlinedloan modication program, mortgages that meet certain criteria can be modied to help borrowersachieve sustainable payments by lowering their housing payments to 38 percent o their gross income(FDIC, 2008). The Homeowner Aordability and Stability Plan creates a $75 billion programto subsidize loan modications that would reduce the monthly mortgage payment o a troubledhomeowner to as low as 31 percent o monthly household income (U.S. Department o the Trea-sury, 2009). In practice, the Oce o the Comptroller o the Currency (OCC) and Oce o ThritSupervision (OTS) (OCC and OTS, 2008) documented that an estimated 133,000 loans weremodied in the third quarter o 2008, a 16-percent increase rom the second quarter o 2008, butthe number o modications continued to all urther behind the number o new delinquencies.
1
  A primary concern with loan modication eorts is the seemingly high rate o recidivism. Within6 months, more than one-hal o all modied loans were 30 days or more delinquent and morethan one-third were 60 days or more delinquent (OCC and OTS, 2008). Do these high rates o redeault imply that loan modications are ailing?Unortunately, the complexity o the many actors involved in loan modications makes thisquestion less straightorward than it appears. Modications do not necessarily reduce mortgagepayments, only some do. Loan modications can lower monthly payments by extending the loanterm, or by reducing the interest rate or the mortgage’s outstanding balance, or by a combinationo practices. Traditional modications, however, only add the delinquent payment to the unpaidprincipal, thus increasing the amount o debt and oten resulting in higher monthly payments(White, 2008). Also, an important temporal aspect to loan modications exists during an extended period o economic downturn. A loan modication may be successul in addressing the initial problem, orinstance, by reducing the monthly payment to address a lack o aordability ater an interest ratereset. As a result o the deepening nancial and economic crisis, however, borrowers can easily acenew problems shortly ater a loan modication, such as loss o a job, which can lead to anothermortgage delinquency and redeault. Thus, it is important to examine the short- and long-termimplications o loan modications.Using data rom a large sample o recently modied nonprime loans, we examine why some loanmodications are more likely to redeault than others. More narrowly, we examine the typeso modications that are more likely to redeault in the short term. As expected, we nd that asignicant reduction in mortgage payment makes modied loans more sustainable in the short
1
During the same period, the number o mortgages delinquent by 60 days or more increased by 17 percent.
 
173
Loan Modifcations and Redeault Risk: An Examination o Short-Term Impacts
Cityscape
term. The ndings also show an even lower likelihood o redeault when the payment reductionis accompanied by a principal reduction. O course, not all loan modications that avoid redeaultare better or the lender. Further studies are still needed to compare the relative eectiveness o dierent types o loan modications based on a net present value analysis.This article proceeds as ollows. The next section reviews the current practices o loan modica-tions and the literature. The third section discusses the data and outlines the logistic models o theredeault behavior o borrowers with modied loans. The ourth section presents and discusses theresults, and the nal section concludes.
Literature Review
Loan modication 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 modications and the literature on the eect o loss mitigation eorts.
Implementing Loan Modications
 As o early 2007, most modications 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 deaults, 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 dicult or borrowers torenance. In late 2007 and early 2008, the prereset modications (interest rate reeze or reduction)on subprime adjustable-rate mortgages (ARMs) increased signicantly. More recently, modica-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 anysignicant degree (White, 2008).The ederal government has relied primarily on encouraging lenders to voluntarily modiy theterms o existing mortgages. In October 2007, a coalition o mortgage servicers and housingcounseling agencies ormed the HOPE NOW Alliance to stimulate a voluntary eort to restructuremortgages. In June 2008, the HOPE NOW Alliance members issued guidelines or a streamlinedoreclosure prevention process or committed servicers. In August 2008, the FDIC, which tookover the ormer IndyMac Bank, launched the rst streamlined loan modication 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.
2
To reach aordable levels, mortgagemodications can combine interest rate reduction, extended amortization, and partial principal
2
I the initial modication 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 aordability. FDIC (2008) provides thetechnical details about the loan modication program.

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