Why Many Home Loan Modifications Fail

That number, it turned out, was too high to qualify for a modification. When told that, the woman said she thought that for at least the next couple of months, they might be able to take only $2,000. That number was too low. She got no modification that day. Had she come up with a number somewhere in between, she might have qualified.

The arithmetic of “Obama mods,” as some call them, is laid out by the government. The 31 percent number is fixed in stone, which provides some simplicity but also can be arbitrary. A family with a lot of other obligations might not be able to afford 31 percent, while one with few other debts could afford much more.

To get the payment down to the 31 percent figure, the bank first cuts the interest rate, to as low as 2 percent, while leaving the other terms of the mortgage unchanged. For the vast majority of mortgages being modified, that is enough. If not, the term of the mortgage is stretched out to as long as 40 years.

Finally, if that is not enough, part of the principal can be deferred. That deferred amount is still owed, but no interest accrues and the lump sum is due at the end of the 40 years, or when the house is sold.

Calculating those numbers is only the first step. After determining the present value of that projected series of payments, the bank then compares it with what it could get by foreclosing. If the bank would be better off by foreclosing, then there is no modification.

One thing working in borrowers’ favor is that foreclosure values are heavily discounted to take into account the delays involved in the process, the costs of maintaining a home until it can be sold and the possibility that property values will continue to fall.

In one case I saw, the house was estimated to be worth $227,100, far less than was owed. The present value of the payments to be made under the modified loan was $159,611. modification was nonetheless approved, and the monthly payment fell to $1,004 from $1,877.

What made the difference was the bank’s conclusion that it would get a present value of just $139,568 from a foreclosure, nearly 40 percent less than the estimated value: the low payments were worth more than the alternative.

All these numbers are based on a lot of assumptions — assumptions that few borrowers will be in a position to know, let alone challenge. And they have the perverse effect that modifications will be harder to get if property values improve, or even if they simply stabilize and seem likely to fall no further. That would make the foreclosure value appear higher to the banks.

It is far from clear that some modifications being granted are really in the borrowers’ interests. Some will be able to stay in homes when they could rent a comparable house for less, and will be so far underwater that they are unlikely to be able to sell the house for years without defaulting on the new terms. It is conceivable that this process is doing more to drag out the foreclosure crisis than to alleviate it.

But perhaps we should not be too critical of anybody involved in the modification effort, either the administration or those trying to arrange modifications. The mess was made years ago, when bad loans were made and the ready availability of credit was driving house values to unsustainable levels. Cleaning it up is not going to be a pleasant experience for anyone.