Loan Modification - Excessive Debts Causing Post-Modification Defaults

Homeowners who get loan modification may be too quick to get back on the spending track, putting them at risk for second defaults. Residential Capital, LLC, one of the country’s leading mortgage servicers, reports that almost half of the loan modifications they granted last year went back into default after less than six months. This has raised the question of whether loan modifications can really prevent foreclosure, or just hold them off temporarily.

Excessive credit

At last week’s meeting with the American Securitization Forum, ResCap CEO Thomas Marano reported that excessive credit was the main reason for most second defaults. According to Marano, once people get their mortgage modifications, many immediately use their savings to load up on other debt (such as credit cards). He adds that the rise in unemployment, resulting from large-scale cost-cutting by major companies, is also working against loan modification programs.

Debt counseling

Marano says that borrowers need to see loan modification as a long-term commitment rather than a one-off solution to mortgage problems. To do this, he recommends putting borrowers through debt counseling as part of the loan modification program. This will help them make smarter decisions on future credit, particularly on credit card spending.

The move will also benefit credit card companies, who are already starting to feel the crunch from missed and late payments. Last week, Fitch Ratings reported that delinquencies in consumer credit hit a record high in the past month—a figure that’s expected to rise if the current loan modification programs aren’t adjusted.

Qualification adjustments

The general requirement for a loan modification is a debt-to-income ratio of about 35%; that is, the mortgage payments must take up no more than 35% of a borrower’s income. According to Marano, however, this figure often exceeds 60% when other debts are taken into account. Working together, these debts virtually ensure a second default, even when the mortgage is significantly modified.

Government support

The government has long supported loan modification as a promising solution to the real estate slowdown, which has been further fueled by recession. However, implementing the program has proven difficult as servicers find it hard to reach out to borrowers. Also working against servicers is their contractual obligation to match their investors’ financial interests with those of their borrowers.

This is why many mortgage servicers, including ResCap, have teamed up with the Federal Housing Finance Agency (FHFA) to boost foreclosure prevention. FHFA director James Lockhart added that the agency plans to help servicers whose profits have drastically declined due to delinquent mortgages.

Principal reduction

Among the measures being taken to expand modification programs is principal forbearance—a permanent reduction of the principal balance on homes that have lost their value. However, Marano says, this may result in moral hazards since many homeowners consider their homes an investment. ResCap is currently working out a “shared appreciation” system wherein the servicer (or its investors) can mutually recover losses from such modifications.

Homeowners’ options

Loan modifications continue to be one of the most viable solutions to mortgage problems. The key for struggling homeowners is to make the right choices both before and after the change, and to work with the right professionals. Attorney-backed loan modification companies can offer sound advice on choosing a loan modification plan and staying on track afterward.