A number of blogs are reporting and commenting on the fact that 50%+ of the loan modifications completed in early 2008 are back in default (see Market Movers Re-Defaults, Naked Capitalism, Housing Wire, and Calculated Risk here and here,
There’s no big mystery as to why most modifications don’t work out.
- Borrowers generally make their payments until they can’t. With home borrowers, that happens when there is some kind of income curtailment (job loss, illness, divorce, etc.) and their savings are gone. With income property borrowers it happens when income from the property no longer supports the debt and the borrowers’ liquidity reserves are depleted.
- If a modification is done, the lender almost always addresses only the income curtailment or operating income problem. So the borrower’s immediate problem is resolved, but there is no safety cushion if there is a new income curtailment or further decline in property income, because the savings/liquidity reserve has not been replenished.
- As a result, any new income curtailment or further decline in project operating income results in an immediate default.
Why do lenders do minimal modifications? Imagine a modification which reduces the interest rate to what the borrower can pay, and provides a deposit into the borrower’s savings account in case they lose their job again or property income declines further. Even if you take a security interest in the savings account (itself an administrative nightmare), someone still needs to advance the funds to set up the account, which will increase the loss reserve on the loan. That’s not likely to happen with a portfolio lender, and the chances are nil on a securitized loan.
Of course, if values have recovered since the modification was done the borrower could sell the property. That hasn’t happened yet, and won’t for a long time. So, we can continue to anticipate most modifications will re-default, because every bump in the the road breaks an axle at this stage of the game.
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