Friday, July 17, 2009

Why Lenders Don’t Modify Loans

Economists at the Federal Reserve Bank of Boston and Atlanta have researched "Why Don’t Lenders Renegotiate More Home Mortgages?". Their conclusion also applies to commercial real estate:

We argue for a very mundane explanation: lenders expect to recover more from foreclosure than from a modified loan. This may seem surprising, given the large losses lenders typically incur in foreclosure, which include both the difference between the value of the loan and the collateral, and the substantial legal expenses associated with the conveyance. The problem is that renegotiation exposes lenders to two types of risks that can dramatically increase its cost. The first is what we will call “self-cure” risk. As we mentioned above, more than 30 percent of seriously delinquent orrowers “cure” without receiving a modification; if taken at face value, this means that, in expectation, 30 percent of the money spent on a given modification is wasted. The second cost comes from borrowers who redefault; our results show that a large fraction of borrowers who receive modifications end up back in serious delinquency within six months. For them, the lender has simply postponed foreclosure; in a world with rapidly falling house prices, the lender will now recover even less in foreclosure. In addition, a borrower who faces a high likelihood of eventually losing the home will do little or nothing to maintain the house or may even contribute to its deterioration, again reducing the expected recovery by the lender.

Adam Levitin at Credit Slips has an excellent follow up post, and makes the point that modifications make sense even after taking into account self cure risk and redefault risk. He also nails the real reason more modifications aren’t being done:

I think servicer capacity is a major concern that applies across the board.  To start with the bulk of servicer personnel at most companies aren't even in the US; they've been outsourced.  Doing a mod is like underwriting a new loan in a distressed situation.  That's a skill, and I don't think it's what servicers were looking for over the past decade when they moved operations to India. Instead, they were looking for low-cost labor for their routine ministerial tasks, and it will take a long time for the industry to acquire the workout talent it needs.

I highly recommend reading both of these pieces – together they will give you a better understanding of modification dynamics than anything else I’ve seen written over the past 3 years.