Why would a bank modify a loan rather than foreclosing? Loan modification is usually more profitable.

Let me explain. Take a typical home mortgage that has run into trouble. The purchaser owns a home that he bought at a price of 350,000 dollars in early 2006. He has fallen behind on the mortgage. He can pay each month but not as much as the mortgage is worth. However and it is a big however, the real estate boom has collapsed. The home valued now is worth only 270,000 dollars. His mortgage payments, his salary and the other facts point to him being able to pay a mortgage of that size. So, the bank would accept a loss on the mortgage reducing it to 270,000 in value. The bank now has a workable agreement with the homeowner. He can now pay on the loan regularly.

There is a 80,000 dollar loss for the bank. That would be a big deal if the bank had any way of getting it. If they foreclose on the house, they will be attempting to resell quickly a home now valued at 270k, and at the additional expense of the time and money of the foreclosure process. That 80,000 is not recoverable. Why not renegotiate a lower mortgage with the current owner who is already making payments?

This key questions here are, “How much is this property worth?” and “Can I get as much by foreclosure as I can by modifying the mortgage?”

Everyone watching the process of foreclosures over the last few years has been struck by one fact – there have been very few loan modifications. Almost every homeowner was foreclosed on. It did not seem to matter whether a modification was profitable or not.

As a society, we had never seen that before. People had been foreclosed on before in every kind of economic crisis. But in all these situations if the banks profited more by modifying the mortgage, the mortgage got modified. Now, it doesn’t matter if the bank profits from a loan modification or not. It’s easier and quicker to foreclose.

Also, it was easier to measure success by foreclosure rather than by re-negotiations. You could count the scalps on the wall. Negotiations that resulted in greater profits over longer periods of time didn’t count well.

The system is tilted against homeowners. The speed and number of foreclosures made it impossible for lenders to renegotiate.

From the Washington Post –

The financial incentives show that the problems plaguing the foreclosure process extend well beyond a few, low-ranking document processors who forged documents or failed to review foreclosure files even as they signed off on them. In fact, virtually everyone involved – loan servicers, law firms, document processing companies and others – made more money as they evicted more borrowers from their homes, creating a system that was vulnerable to error and difficult for homeowners to challenge.

“This was a systemic problem. It’s not like a few renegade employees made mistakes,” said lawyer Peter Ticktin, who defends Florida homeowners facing foreclosure. “It was industry-wide and pervasive, and everyone knew about it.”

The need for speed neutralized any attempt at judgment. No human intelligence could be allowed to interfere with number and speed, a total victory of the abstract over the concrete and real. Loan modifications are better for long term profits but they are not fast.

Understand this. In any long term profit making analysis, you have to apply human judgment, and from that you can maximise profit. The foreclosure system we have now does only one thing well – foreclose quickly. Everything else is does badly.

James Pilant