Why did lenders modify so many loans during the housing bust?
Unilaterally modifying home mortgages was a necessary step to ensure banks survived the housing bust.
Ostensibly, homeowners and lenders agreed to the price of money (interest rate and payment) when the promissory note was signed. Unfortunately, during the housing bubble, the terms of these notes were onerous, and many borrowers faced excessive monthly housing costs while simultaneously facing declining house prices and the elimination of their equity.
With no equity, little hope of future equity, and rising payments, many borrowers opted to strategically default — and lenders worried that more would follow. Banks were still exposed to $1 trillion in unsecured mortgage debt when housing collapsed. The threat of strategic default and the reality of a trillion dollars in unsecured debt forced the banks to renegotiate the terms of the original promissory note, and loan modifications became a feature on the real estate landscape.
Lenders don’t want to make loan modifications. If the borrowers had equity, they would simply foreclose on them and get their money back. Since so many were so far underwater, the banks couldn’t foreclose on them and get all of their money back, so it was in their best interest to cut deals, amend loan terms, kick the can, and pray their borrowers made payments until prices came back.
Once prices reached the peak, things changed back in favor of the banks, and their motivation to make loan modifications vanished. Many people view loan modifications as a new housing entitlement. Beyond the new statutory requirements, it won’t be.
The moment borrowers are no longer underwater, the entitlement is rescinded by the banks. Remember, they would rather foreclose and get their money back so they can loan it to someone who will make payments based on the original contract terms.
The money rentership negotiation
The negotiation of terms for loan modifications is unique. Never before were so many been in such circumstances, so there was no precedent for this activity. Ordinarily, the lender wields far more power than a landlord because the eviction of a homeowner (also known as a foreclosure) trashes the credit score of the borrower.
Lenders demand payments for renting money that exceeded the fair market rent on the property — and homeowners willingly paid it, partly out of fear, and partly out of greed. Borrowers feared the ramifications of the foreclosure, but they also believed prices would come back, and they would still make a fortune on home price appreciation — albeit delayed by a decade.
For example, let’s say a loanowner was facing a $3,500 payment on a property that rented for $2,000 — a common occurrence in the aftermath of the housing bubble in California. The borrower could have simply strategically defaulted and squatted until the lender foreclosed. They could then rent a similar property for $2,000 per month. Many followed this path.
However, after examining the borrower’s finances, many banks offered a loan modification that reduced the payment to $2,500 interest-only on a temporary basis if the borrower started paying again. Since the bank made up the formula anyway, they spit out whatever number they believed they could get the borrower to pay. Since the borrower had credit consequences to walking away in favor of rental, and since the borrower maintained hope of future equity, many borrowers paid the extra money to stay in the house.
The win-win of rising prices
Every underwater homeowner was a potential loss for the lender. If that borrower stopped paying or asked for a short sale before prices reach peak valuations, the bank absorbed a loss.
Banks don’t want to recognize losses either by foreclosure or short sale. They would far prefer to borrowers to stay in their homes, pay something, and wait for house prices to reach the peak where lenders had no exposure. Most homeowners were happy to play along. The only thing lacking up through early 2012 was rising prices to give both lenders and homeowners hope.
To get prices to go back up, lenders needed to drastically reduce the MLS supply to create a false shortage the forces buyers to compete and bid prices up. Once prices started to rise, and once homeowners believed the rise was sustainable, many of them signed up for loan modifications. As far as lender and homeowners are concerned, this was a win-win. The only losers in this scenario are future homebuyers, and as I’ve pointed out before, nobody cares about them.