Deleveraging the American Homeowner: The Failure of 2008 Voluntary Mortgage Contract Modifications

The subprime foreclosure crisis has resulted in residential mortgage debt burdens far beyond what borrowers can repay. Many economists have recognized the need to deleverage the American homeowner. Empirical evidence from mortgage servicer reports to investors show that for the most part, the necessary deleveraging of homeowners is not happening. This Article reports on a study of data from more than 3.5 million subprime and alt-A mortgages, including about one-sixth of all foreclosures pending, and about 20% of the monthly total modifications in November 2008. The key findings are the following: (1) modifications are not reducing principal debt, they are increasing it. Almost no modifications include significant cancellation of either past due interest or principal, and many modifications involve capitalizing unpaid interest and fees and reamortizing the loan, which occurred in 68% of loan modifications. Some principal was canceled, and reported as a partial loss, for about 10% of modifications; (2) servicers are incurring huge losses for investors by foreclosing. The average foreclosure loss on a first mortgage in November 2008 was $145,000 or about 55% of the average amount due. Loss severities increased steadily throughout 2007 and 2008 and are expected to worsen in 2009. In these circumstances, rational investors should accept mortgage principal reductions corresponding to home value declines of 20% or so, were it not for the various obstacles to servicers’ restructuring of mortgage loans; (3) fewer than half of voluntary mortgage modifications reduced monthly payment burdens; (4) the variations among servicers in the number and quality of modifications are enormous. This variation suggests that not every servicer is doing the maximum possible to reach and work out terms with every defaulted borrower; (5) many modifications are temporary. For example, some adjusted interest rate and amortization terms were only for five years, with rate and payment increases after five years. Servicers also use balloon payments and other forms of deferrals in order to reduce payments without reducing total debt. Thus, the totals reported by the industry include many loans that are being modified to include deferred payment shocks, negative amortization or other non-amortizing features of the sort that caused the foreclosure crisis; and (6) significant numbers of mortgage loans are seriously delinquent, but not in a modification program or in foreclosure. The foreclosure crisis is overwhelming the ability of servicers to either restructure or foreclose on all the delinquent loans. The Article discusses the many reasons why necessary mortgage restructuring is not happening and proposes several policy responses