johnnymk

http://seekingalpha.com/article/1475...s?source=email

At the center of most efforts to provide relief to struggling homeowners is an attempt to take on a single housing paradox: Banks get a much better return on a mortgage modification than they would on a default, foreclosure, and sale, and yet banks renegotiate only a tiny share of seriously delinquent mortgages—only 3% or so. This is money left on the ground, and the key to helping homeowners would seem to be knocking down whatever is standing between banks and this opportunity for mutual gain.

That whatever, in most tellings, is securitization. The pooling and chopping of mortgage payment streams that is part of the securitization process would seem to pose a significant structural barrier to loan modifications. But is this actually the case?

A new paper (.pdf) by Federal Reserve economists Manuel Adelino, Kristopher Gerardi, and Paul Willen argues that securitization is a red herring. They note that there is no significant difference in the rate of renegotiation of banks' securitized loans and other, non-securitised loans held in bank portfolios. Whatever is keeping banks from modifying delinquent mortgages, it's affecting all delinquent loans.

In fact, Mssrs Adelino, Gerardi, and Willen argue that the real mistake is a misstatement of the initial paradox. If banks aren't taking advantage of an opportunity to increase the return on loans by modifying terms, then perhaps that's because no such opportunity exists:

We argue that the data are not inconsistent with a situation in which, on average, lenders expect to recover more from foreclosure than from a modified loan. At face value, this assertion may seem implausible, since there are many estimates that suggest the average loss given foreclosure is much greater than the loss in value of a modified loan. However, we point out that renegotiation exposes lenders to two types of risks that are often overlooked by market observers and that can dramatically increase its cost.

The first is “self-cure risk,” which refers to the situation in which a lender renegotiates with a delinquent borrower who does not need assistance. This group of borrowers is non-trivial according to our data, as we find that approximately 30 percent of seriously delinquent borrowers “cure” in our data without receiving a modification.

The second cost comes from borrowers who default again after receiving a loan modification. We refer to this group as “redefaulters,” and our results show that a large fraction (between 30 and 45 percent) of borrowers who receive modifications, end up back in serious delinquency within six months. For this group, the lender has simply postponed foreclosure, and, if the housing market continues to decline, the lender will recover even less in foreclosure in the future.

Once both types of risk are taken into account, the expected return on a loan modification is likely to be lower than the return to foreclosure. If this is, in fact, the case, then the problem facing policymakers is much more difficult than previously imagined. Helping borrowers can't merely be accomplished by clearing away some institutional barrier to a means to mutual gain. Banks are sending these loans into foreclosure for good reason, and taxpayers would have to pony up some serious cash to prevent banks from doing so.

This article originally appeared on The Economist.com