The last chance for bankers to voluntarily modify mortgages may be at hand.
For the past year and a half, the government has pressed for modifications and set incentives for them but has stopped short of forcing them. Though servicers have pledged to improve their efforts, progress has been slow, and many still refuse to modify loans in ways that lead to lower payments for the borrower.
The result is a wave of redefaults and increasing evidence that public and private efforts to stop the foreclosure crisis have failed.
Observers say if changes being pressed by the Obama administration cannot improve the situation, Congress or regulators are likely to take more drastic action, including a renewed push for legislation to allow judges to rework loans in bankruptcy.
"If modifications don't pick up, I think mortgage bankruptcy returns with a vengeance," said Jaret Seiberg, a policy analyst with Washington Research Group. "Bankruptcy is the tool that the government can use to modify contract terms without incurring liability. If we enter the fall, and we've helped hundreds of people rather than tens of thousands, there's going to be tremendous pressure to pass full-scale mortgage bankruptcy. So there's a lot riding on the implementation of the mortgage modification plan."
The bankruptcy reform bill failed a critical vote in the Senate last week after negotiations with the industry broke down, but several policymakers have vowed to return to the issue.
The Obama plan remains the best chance yet, many said, to stem the tide of foreclosures, in part because it would force servicers at least the ones who volunteer for the program to do what many have avoided so far: lower borrowers' monthly payments.
Up to now, modifications performed by a large portion of the industry have redefaulted at a rate of around 50%. But many of those modifications did not actually address the borrower's ability to pay the loan.
"A lot of the modifications are repayment plans," said Mark Zandi, chief economist and co-founder of Moody's Economy.com. "They're not reducing the monthly payment or the principle amount. They're really not providing any relief to the distressed homeowner, and that's just not going to work."
Observers say the government's latest approach could effectively force servicers to lower borrowers' monthly payments and close the gap between the current value of a home and the outstanding loan.
Under the Obama plan, servicers that volunteer of which 12 have to date, accounting for roughly 75% of outstanding mortgages would be required to lower borrowers' monthly debt-to-income ratios to 31%.
Tougher modification standards could translate into a lower redefault rate. Mortgages owned by IndyMac and modified through the Federal Deposit Insurance Corp.'s (FDIC) plan, which required borrowers DTI ratios to be lowered to at least 38%, are showing a redefault rate of just 12%, according to the FDIC's latest data, released at the end of March.
Other changes announced last week would require participating servicers of second mortgages to do matching modifications on those second loans, which could mean an even sharper reduction in some borrowers' monthly payments. "This plan at least restores the notion of lien priority at some level," said Pete Mills, a consultant to Potomac Partners and a former lobbyist for Countrywide Financial. "Because of the precarious position of the second-lien holder, I think this will in general be a positive move forward, but it's not going to be a slam dunk. I think there will be some hiccups along the way."
Industry participants also said the specific requirements for modifications under the administration's plan would prevent servicers from performing the more halfhearted versions of old.
But economists predict that foreclosures will continue to increase, and their growing numbers could overwhelm the administration's efforts. Zandi said he expects foreclosures to rise throughout the summer, "swamping the record for foreclosures that we've seen to date."
If this trend plays out and home values drop further, fewer borrowers may be motivated to stay in their homes and keep paying their mortgages. That would increase pressure on policymakers to force banks to write down mortgage principle, a step most have been unwilling to take.
"At the end of the day," Zandi said, "my feeling is that they're really not going to address this issue unless they have a modification plan that involves some incentives for principle writedowns."
Regulators first noted that lowering monthly payments was an effective way to modify mortgages back in August 2007. And since then both state and federal regulators have concluded in separate reports that bank loan modification programs needed to be improved.
The Office of the Comptroller of the Currency and the Office of Thrift Supervision, in their joint quarterly report released early last month, noted that the rate of redefaults had risen for loans modified in 2008.
So why are regulators failing to get through to bankers? Some observers said the agencies are trying to do too much in too many areas and their message was muddled at best and contradictory at worst.
"The government does not have a consistent approach to the banking industry," said William Isaac, a former FDIC chairman. "There is no one plan. It's as if every other week there's a new plan, a new direction. Bankers are just they really don't know which way to turn anymore."
Alan White, a professor at Valparaiso University Law School who has been monitoring servicers' foreclosure prevention efforts, said servicers may not have realized the gravity of the situation.
"There is no point" to modifications that do not lower payments, he said. "It's being done out of habit; it's being done because that's what [servicers] used to do; in this environment, that's totally counterproductive."
Others said servicers have been reluctant to make more dramatic changes to a loan if smaller adjustments would preserve a loan's value for investors.
"The actual people on the ground who are charged with doing the modifications are responding to the general problem that their lenders don't really want to lose money on these things," said John Weicher, director of theCenter for Housing and Financial Markets at the Hudson Institute. "They're hesitant to offer modifications if they're questioning what the outcome is going to be from their standpoint."
But Weicher, a former federal housing commissioner, said, "There's a lot of room for negotiation in this situation. I'm surprised that hasn't happened to this point, that people haven't been taking more vigorous action on the lender side. It seems to me it's pretty clearly in the financial interest of borrowers and lenders regardless of the administration's efforts."