Front Office

Remember all those loan modifications that Countrywide was forced to dole out in the aftermath of the financial crisis? As it turns out, a fairly high percentage of the homeowners who received those loan mods got them by way of strategic default.

According to a recent research paper authored by Xianghong Li of York University’s department of economics and Xinlei Shelly Zhao, who works for the U.S. Office of the Comptroller of the Currency and in Kent State University’s department of finance, “There is clear evidence that the modification program not only increases default rates among loans current in their payments, but also significantly shrinks the cure rates among borrowers who were already past due in their payments ...” According to the pair’s research, “By January 2009, modification-induced strategic default [in the Countrywide program was] about nine percentage points, on a base default rate of 30%.”

The paper further finds that “modification-induced strategic defaults are rather widespread, and this behavior seems to be more serious among more risky loans, such as those paying interest only, balloon loans and those already delinquent in the mortgage payment at the time of the modification announcement.”

What’s more, homeowners who are underwater on their mortgages are much more likely to redefault after getting a trial or permanent loan mod.

Some of these same homeowners were previously in good standing and may have intentionally missed one or more payments just so they could get a sweet loan mod like their friends and neighbors.

This, of course, raises a question as to what good all those loan modification programs - including the Home Affordable Modification Program - did relative to the cost and effort that was put into them. It’s been well established that a high percentage of homeowners who received loan modifications returned to default - but what of the strategic defaulters? How many of them redefaulted?

The problem of loan mod fraud, of course, stems mainly from the fact that modifications are not underwritten using the same criteria that is used for underwriting newly originated mortgages. Not only that, but no two servicers underwrite their proprietary loan mods quite the same way.

Making the problem difficult to measure is the fact that there is no true definition for loan mod fraud: As the paper points out, the “scope of such behavior is difficult to assess because the true cause behind any default is largely unobservable.” In other words, there is no way for a servicer to truly know the underlying cause for a default - particularly without doing a deep dive into a borrower’s financial records.

With delinquencies and foreclosures falling dramatically, and loan mod volume dropping correspondingly, this might seem like a non-issue. But, it is an issue when one looks at it from a moral, ethical or sociological standpoint: As borrowers become more savvy in their understanding of how loan mod programs work - and how these programs can be “gamed” - it can be expected that loan mod fraud will only continue. Therefore, it is important for policymakers to consider how such programs alter borrower behavior.

“There is a general consensus that strategic defaults are costly, as they not only increase the cost of modification programs, but may also weaken the moral standard of the society,” the paper states. “If some debtors are perceived as being bailed out unjustly, more strategic defaults might follow.”

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