Loan Servicers and Modification: the Critical Flaw in Satisfying Our Self-Interest

Since I've been blogging incessantly about the grinding, often needless, sometimes unlawful, disaster that is the foreclosure wave, I was heartened to read in this week's New York Times an article by Gretchen Morgenson that acknowledged both the irrationality of some foreclosures and the severe external costs they impose on others.  But Morgenson's article does more: it pinpoints the flaw that is producing these disastrously irrational results.

Happily, the article describes the successful effort of a homeowner to modify their mortgage loan in order to keep their home -- an effort that became successful only after the New York Times contacted the borrowers' loan servicer.  But such modifications are exceedingly rare.

Morgenson accurately notes that "millions of Americans have been sucked into the foreclosure maelstrom that is ruining their finances and their lives."  The fundamental question about the foreclosure wave, according to Morgenson, is: "should homeowners simply [continue to] be foreclosed upon en masse, or should banks work with them to modify mortgages and reduce the loans to levels that homeowners can manage?"  Perhaps another, equally important question is, why should we care?

The answer is simple: it's in our self-interest to care very deeply that banks modify mortgage loans to prevent foreclosure.  That may seem counter-intuitive: why would it be in our self-interest to, in essence, reward borrowers who borrowed irresponsibly during the housing market madness of recent years?

Here's why: in Morgenson's words,

Foreclosures blight neighborhoods, put financial pressure on families and drive down local real estate values.  Investors who hold loans in securitization trusts are also hurt be foreclosures, because recoveries on these properties are low.  And consumers, made more cautious by a crippled housing market, spend less freely, curbing the economy's growth.

So, why, then are loan modifications exceedingly rare?  Because one group is profiting immensely from foreclosures: loan servicers.  The very same people that most borrowers first contact seeking loan modification.  As Morgenson says, "loan servicers can profit significantly by pushing borrowers into foreclosure."

In other words -- and this is absolutely critical to understanding the foreclosure wave -- loan modifications are in the self-interest of every actor affected by foreclosures except the one actor to whom borrowers first turn when seeking a modification: loan servicers.  Loan servicers have the opposite incentive: to refuse modification and force foreclosure.  Loan servicers are externalizing the costs of foreclosure onto the rest of us, and internalizing the benefits.  That, of course, is what they should do, as rational, profit-maximizing entities.

We need to change the rules of the game so that it is in loan servicers' self-interest (through carrot, stick, or a combination of both) to permit loan modification.  Until we do, loan modification will remain exceedingly rare and foreclosure will continue, catastrophically, en masse -- even though it is in nearly every party's interest that just the opposite is true.  

Mark A. Edwards

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