Rewriting contracts, wholesale: data on voluntary mortgage modifications from 2007 and 2008 remittance reports.

• Author: White, Alan M.

Introduction I. Loss Mitigation and Loan Modifications: the Voluntary Approach. II. Study Method III. Loan-Level Data on Mortgage Refinancings, Defaults and Losses During the 2007-08 Crisis A. Growing Defaults, Foreclosures and REO B. Losses on Foreclosed Properties: Loss Severities Worsen C. Refinancing Option Fades Away IV. The Loan Modifications--The Nature and Scale of the Effort A. Virtually No Principal Reductions, Some Payment Reductions B. Modifications Compared to Foreclosures C. Variability Among Servicers D. Adjustable Rate Loans and the Payment Shock Issue E. Discussion Conclusion INTRODUCTION

The 2007-08 credit crisis in the United States, precipitated by defaults on subprime mortgages, resulted from a classic debt bubble, featuring massive borrowing on the basis of rapidly inflating asset values, in this case residential real estate. (1) Debt crises can be resolved quickly or slowly. Crisis resolution invariably requires that the underlying asset values return to normal levels and that debt which will never be paid off by borrowers be written off, with or without massive transfers of the underlying assets. (2) The revaluation of assets and write-down of debt can be accomplished in several ways, including government bailouts, currency inflation (which shifts losses from borrowers to lenders), legislation, asset seizures by lenders and subsequent resales, or by the slow workings of the market. (3) The losses can be borne by lenders, borrowers, taxpayers, or some combination of these. (4) To take an example from the Great Depression, U.S. debts were written down by 50% or more in 1935 through the legislative expedient of voiding gold clauses in contracts. (5) Taxpayers absorbed the losses from the savings and loan crisis of the 1980s. (6) Japan's "lost decade" in the 1990s offers an example of the slow and agonizing approach to resolving a debt crisis. The central bank and government were unwilling to require banks to write down their assets and instead allowed overvalued debts to remain on the books in the vain hope that they could eventually be repaid, causing a huge drag on the national economy for more than a decade. (7)

Home mortgage debt in the United States mushroomed from about $4 trillion in 1998 to $10 trillion in 2007. (8) During the same decade, the median income remained virtually unchanged in constant dollars, (9) and the number of homeowners rose at a relatively modest pace. (10) Inevitably, homeownership has become progressively less affordable, and the ability of Americans to service their growing mortgage debt has reached a breaking point. (11) The rapid growth of subprime mortgage lending was an important contributor to the mortgage debt bubble.

In the case of the August 2007 collapse in the subprime mortgage market, U.S. policy-makers have recognized the need for some sort of intervention to readjust home values and mortgage debt, but have to date been unwilling to use the tools of taxpayer-funded bailouts or legislated debt reduction. Instead, the Treasury Department encouraged voluntary efforts by mortgage servicers, on behalf of the investors holding the inflated debt, to renegotiate the terms of residential mortgages. (12) Lenders and mortgage servicers, faced with rapidly escalating foreclosure rates, plunging home prices, and mounting losses, were exhorted to renegotiate mortgage terms with borrowers in order to stave off even more widespread defaults and foreclosures.

A year into the crisis, it is possible to begin evaluating the success or failure of these voluntary efforts to resolve the debt overhang by renegotiating contracts one at a time, albeit on an unprecedented scale. Data on voluntary mortgage modifications are available from a number of sources, including the HOPE NOW ad hoc coalition of mortgage servicers and counselors, the Mortgage Bankers Association, and the working group of state banking and consumer credit regulators working on the foreclosure crisis. (13) These data provide some evidence as to the effectiveness of the voluntary restructuring approach, which aims to avoid any taxpayer contribution and to allocate losses between borrowers and lenders on a negotiated, and hopefully optimal basis. (14) On the other hand, the various available reports do not specify what kind of modifications are implemented, and the degree, if any, to which mortgage debt is being reduced to a more sustainable level.

To supplement the national reports on mortgage modifications, this paper analyzes data derived from monthly remittance reports by mortgage servicers to their investors, which provide rich detail on individual mortgage foreclosures and modifications. The selected sample consisted of monthly reports from July 2007 through June 2008 for twenty-six different subprime loan pools, and included data on 4,344 loan modifications. The data include the loan balance, monthly payment and interest rate, before and after modification. This Article will begin by reviewing some history of the voluntary plan to resolve the subprime mortgage crisis and the previous reports on voluntary loan modifications. It will then present the new data from remittance reports, and in particular on two key outcomes of loan modifications: whether total mortgage debt is being reduced, and whether monthly payments for individual homeowners are reduced.

1. LOSS MITIGATION AND LOAN MODIFICATIONS: THE VOLUNTARY APPROACH

   While bankruptcy regimes can be a useful means to realign debts and asset values, the U.S. Bankruptcy Code specifically forbids bankruptcy judges from modifying most residential mortgages by reducing the debt to the market value of the property. (15) Efforts in Congress to amend the Bankruptcy Code and permit judges to impose debt restructuring through principal reduction have thus far met stiff resistance from the banking industry, and consequentially have been stymied. (16) Without a bankruptcy regime (or something comparable) as a coercive tool, homeowners have little choice but to attempt to negotiate concessions, such as interest rate reductions or payment deferrals, individually with their servicers.

   A significant portion of the $10.5 trillion in mortgage debt owed by Americans by 2008 (17) consisted of subprime mortgages, and this trend continues to grow. (18) By the end of 2007 mortgage debt exceeded total aggregate home equity (in other words, Americans had borrowed more than half the value of all homes in the country) for the first time. (19) Although home prices began declining in 2007, and dropped by 20% or more in some areas, housing affordability had not improved much by the middle of 2008 because home prices were still out of the reach of many Americans. (20)

   The subprime credit crisis reached the breaking point in August 2007 after several investment funds relying heavily on subprime mortgage derivatives collapsed, securities affected by subprime defaults were discovered in bank portfolios around the world, interbank lending suddenly froze, and the Federal Reserve and European Central Bank had to inject billions of dollars and euros into the international financial system. (21) As the subprime crisis unfolded, home values that had risen to unsustainable levels began to decline. (22) At the same time, increasing numbers of homeowners defaulted on their mortgages and faced foreclosure. (23) Investors had assumed that in the event of defaults, securities backed by U.S. home mortgages would be safe, because the homes securing the mortgages could be foreclosed and sold to recover any unpaid loans. In practice, however, subprime mortgage servicers rarely recover 100% of the debt in a foreclosure. (24) After the 2007 crisis, the combined effect of high foreclosure rates and plummeting home values meant that foreclosure recovery rates (usually measured as loss severities (25)) progressively worsened. Bond rating agencies have predicted loss severities on subprime foreclosures as high as 50%. (26)

   In this environment, it makes economic sense for mortgage servicers, on behalf of lenders and investors, to seek alternatives to foreclosure by restructuring mortgage loans with borrowers, where the borrower can be expected to repay even 80% or 90% of the original debt. (27) Wooden insistence on adherence to the original contract terms may result in the servicer recovering far less than if the contract is modified. Borrowers who are unable to pay subprime mortgages on their original terms may be able to make reduced monthly payments. Payments may be reduced by dropping the interest rate or the loan balance, or both. Borrowers whose mortgage debt exceeds their home value may have an incentive to default, but that incentive can be reduced if the servicer agrees to write down the loan balance to the property value. (28) Resolution of the mortgage debt crisis without truly massive foreclosures thus depends on loan modifications that accomplish two things: reducing principal debt and reducing monthly payments. Based on these arguments, Bush Administration officials and bank regulators called on mortgage servicers to negotiate interest rate and principal reductions by modifying mortgage contracts, as an alternative to foreclosure, in appropriate cases. (29)

   Securitization of mortgages has added layers of difficulty to the task of loss mitigation for subprime mortgages. (30) Servicers face constraints on their ability to renegotiate mortgages, and have little economic incentive to incur the additional cost of loan modifications. (31)

   On October 10, 2007 Treasury Secretary Henry M. Paulson, Jr. announced the formation of a coalition of mortgage servicers and housing counseling agencies, called HOPE NOW, to stimulate a voluntary effort to restructure mortgages, and ostensibly to respond to the subprime foreclosure crisis without mandatory debt restructuring measures or a taxpayer-financed bailout. (32) In December 2007, the HOPE NOW coalition announced an initiative to encourage...