Report Questions Effectiveness of Loan Modifications

A new study is raising doubts about the effectiveness of mortgage loan modifications as a means of providing relief to financially stressed homeowners.

Between two-thirds and three-quarters of all modified subprime mortgages will fall back into default within 12 months of modification, according to the report from financial analysis firm Fitch Ratings. Modifications that reduce the principal owed were found to be more successful, but even those were found to re-default at a rate of 40-50 percent after 12 months.

"Loan modifications hold clear value for many homeowners provided the modified payments are sustainable, but more often than not reducing the home payments to an affordable level may not be enough to rescue borrowers who are overextended on other credit and expenses,"said report author Diane Pendley, as quoted by BusinessWeek. "With continued home value declines in many markets, there is growing evidence that some homeowners are voluntarily walking away from their homes even if they can financially afford to stay."

Reducing principal yields more success

Another study that came out Tuesday, by LPS Applied Analytics, concluded that principal reductions have a 25 percent less chance of default in the first six months than other types of loan modifications. The reports are likely to give added support to housing analysts who have been arguing that reducing the principal owed on a mortgage is more effective way to avert foreclosure than tweaking the interest rate or making other changes in terms, particularly when the balance owed exceeds the market value of the home.

Many lenders and government agencies have been promoting mortgage loan modifications as a means of helping homeowners avoid foreclosure and keep their homes. Mortgage loan modifications are a major element of the Obama Administration's Making Home Affordable program. According to the Wall Street Journal, loan modifications accounted for 56 percent of all foreclosure avoidance agreements between borrowers and lenders in the last six months of 2008, up from 31 percent the month before.

Office of Thrift Supervision sees better results

The U.S. Office of Thrift Supervision is more optimistic about loan modifications, but still predicts that 41 percent to 46 percent of the 1.6 million mortgage modifications completed since 2007 will eventually fail. The Fitch report is based on an analysis of mortgages repackaged into mortgage-backed securities from 2005-2007, so its results may be skewed by the fact it is based on relatively new mortgages where homeowners may not have built up much equity in the property.

Loan modifications may be any of a variety of ways to make a mortgage more affordable without refinancing it outright. They may include temporarily reducing the interest rate, postponing some charges or late payments until the loan matures, setting up repayment schedules missed payments or other measures.