Fed Research Sheds Light On Reluctance Of Subprime Lenders To Modify Loans


I came across a research paper published by the Boston Federal Reserve Bank where the researchers looked into among other things a mathematical formula that demonstrates subprime lender have little financial motivation to modify mortgages facing default.

This research I thought was interesting because I am caught between wanting the government or the lenders to “help” foreclosure victims, especially if they were tricked or lied to (a typical practice among subprime mortgage sellers). Of course, everyone on the planet knows best how to accomplish this “helping”. I on the other hand don’t. Nor do I have the arrogance or stupidity to believe just throwing money at defaulted homeowners will work any better than burying the banks in mountains of cash thawed a “frozen” credit market.

So are we stuck with the alternative…do nothing?

Maybe that is the best answer. Do nothing and let the real estate market absorb all the foreclose homes at depressed prices. This will eventually mean a bottom in home price gets hit or what economists call an “equilibrium”. The theory goes this will happen anyway and the only thing the Feds or lenders can do with too much “help” is slow down the inevitable. If that’s true, well-meaning “help” turns out to be “hindrance”. Not good…

I don’t know…this “free market equilibrium” rationale sounds very self-serving for the banking and mortgage servicing industries. Am I biased against it just because it aligns with the wants of an obviously crooked couple of industries?


When I get caught in a “bias debate” with myself it can go on forever, so I seek out facts and figures to make the differences. Enter this new report…

Subprime Mortgages, Foreclosures, and Urban Neighborhoods – Authors: Kristopher S. Gerardi and Paul S. Willen

In the report, I found a few nuggets of gold to help me break the logjam.

First, the reason for the subprime lenders do NOT want to help is the fact that according to fairly simple “risk vs. reward” calculation, lenders know that most underwater borrowers will in fact pay!

Did you get that?

The worst hurt by this subprime meltdown, the lowly subprime borrower…those horrible folks who “took advantage”…even after losing a ton of equity…those folks will find a way to pay. Under this scenario the banks lose nothing…so why modify a loan with a costly principal or rate reduction.

We all forget to ask for the numbers in a fervor to “act” or “help”. In the case of subprime borrowers, the numbers show most will pay even when you or I might walk away.

Here’s a chart

subprime modification chart

The chart shows even with a negative equity of 20% a prime and subprime borrowers’ chances of foreclosure are 4 and 33 percent respectively. Yes, subprime borrowers will default at a much higher rate than prime borrowers, but we should still remember if 33% default, that leaves 67% who don’t. That reflects a majority who don’t default under the same conditions.

A quote from the report,

“Specifically, many commentators have recently argued that lenders should eliminate negative equity for borrowers in such a position by writing down a portion of the principal balance on their loans. The argument runs that such a plan benefits the lender as well as the borrower because the new principal balance exceeds the yield from foreclosure, once one takes into account the costs of foreclosure. Many commentators have argued that this solution is so obvious that one wonders why lenders do not implement it on a large scale. In the following discussion we show why lenders have not engaged in such a policy as a matter of course, but we also argue that for multi-family properties in the inner city, such a scheme
might work.

There is a serious flaw in the logic of principal reduction. To see why, it is useful to think of two mistakes a lender could make. One mistake is to not offer assistance to a borrower in distress. The lender loses here if the increased probability of foreclosure and the high costs incurred by foreclosure make inaction more costly than assistance. We call this scenario “Type I Error.” But there is another mistake, often overlooked, which is to assist a borrower who does not need the help. The lender loses here because it receives less
in repayment from a borrower who would otherwise have paid off the mortgage in full. We refer to this case as “Type II Error.”

Type II error is precisely the reason that lenders rarely engage in principal reduction. One lender summed it up this way, “We are wary of the consequences of being known as a bank that forgives principal…we have not to date forgiven any principal.” Some have suggested that principal reduction would benefit investors, but that complex agreements between servicers and investors make such a policy infeasible. However, the evidence for this explanation is severely lacking. For example, Freddie Mac, which retains credit risk when it securitizers a mortgage, and thus has complete discretion over the disposition of troubled loans, rarely grants any loan modifications. Furthermore, for the instances in which it does offer assistance, few involve any “concessions” like principal or interest rate reductions.”

Why don’t we have more meaningful foreclosure asistance…prinicpal and/or rate reductions? Because lender’s …”are wary of the consequences of being known as a bank that forgives principal…”.

But is this because the banks are simply horrible, evil people with no compassion…or is it due to some macro-economic theory of hitting bottom unimpeded?

Nope…on both accounts!

The real interesting part of the study comes when the algorithm gives both types of credit borrowers back a 10% percent equity stake in the home and recalculates the foreclosure probability and the “Net Gain” between Type I and Type II Errors.

Looking at this we see the probability of foreclosure on the prime borrowers barely move but on the subprime borrower it drops considerably…from 33% down to 9%. One the surface, you’d think that would support the idea lenders and policy makers could benefit from a “principal reduction” strategy.

But wait…

We still have a negative net gain number even after simulating a principal reduction for all home-owner borrowers. The authors define the chart this way…

Type I error measures the cost of not assisting borrowers who need help. Type II error measures the cost of assisting borrowers who do not need help. The net gain to the lender, as shown in Section 6, equals the difference between Type I and Type II error.

So the researchers factored in the cost of the “accidental helping” of those who didn’t need it…which does occur when you do en mass loan modification ala Sheila Blair’s method. With this factored in, the subprime borrower now shows a negative “Net Gain” of -12.7%. The bank loses money even after reducing the principal amount…a no-win situation.

Combine this fact with the fact that 67% of subprime home-owner borrowers were going to pay in full without any help whatsoever, we get a reluctant banking industry when it comes to principal reduction loan mods.

It appears to me it’s a double standard for us to ask the banks to “help” subprime foreclosure victims in a way that loses them money. At the same time, preaching “Be smarter next time”. They are just trying to ‘be smart’ right now.

Of course, it really won’t matter because Congress and other politicians are already geared up to spend about $100 billion at last check to “help foreclosure victims”. I feel I can now say with certainty, no scheme of “helping” homeowners with principal “cram downs” or government investing in the “underwater” portion of their home will solve a thing.

I say this with equal parts relief that the debate is over…and overwhelming sadness the only logical conclusion means, in this case, “help” turns into hindrance.

I really wanted it to go the other way….

About Author

Rob K. Blake, a 15 year veteran of the mortgage industry, is a renowned public speaker, author, and former radio talk show host. His blog, TheMortgageInsider.net, is dedicated to educating mortgage consumers, mortgage providers, and investors about both mortgage and housing markets.


  1. Pingback: Top 10 Smart Markets To Purchase A home In For 2009 : The Real Estate Bloggers

  2. Prof. Samuel D. Bornstein on

    Everyone admits that the core of the problem are the “Troubled Assets” or the so-called “Toxic” Mortgages. The key to a solution to this Economic Crisis is the Borrower’s ability to make the monthly mortgage payment.

    This reminds me of a quote from Winston Churchill in 1943…”Never before have so many owed so much to so few”.

    The simple fact is that the underlying assets of the Mortgage Backed Securities and other related investments are the “Toxic” Mortgages.
    Everyone is betting that the Borrower will default and that foreclosure will follow. The key to increasing the valuations of these securities is the Borrower’s ability to avoid default.
    The Borrower’s track record is poor. Note that after loan modification, the Re-Default rate is 60% within 6 months!

    The Borrower’s failure is to be expected. After all, the borrower has no “understanding” to make informed financial decisions. He is like a “boat without a paddle”. How can he deal with his complex financial environment? He is like a “Prehistoric Man” in a “21st Century body”.

    No Loan Modifications or Bailouts will work unless we address the cause of our great financial crisis…The Borrower has no concept of managing his/her money.

    Bailout will not work. It is similar to taking a “drug” for an illness. Sometimes the “side-effects” are worse than the disease. Sometimes proper “diet and exercise” will cure the disease without complications. That is precisely what we need now. A “natural” cure, not a “drug”.

    We are “up against the gun”. There is not much time to embark on a so-called program of Financial Literacy, which has been proven to be a complete failure. The Gov’t has spent millions on these Financial Literacy initiatives that simply disseminates “information”. What is needed is an initiative to help the borrower “understand” how to manage money and avoid the pitfalls that have previously caused financial distress.

    The solution is a program of “Immediate and Specific Financial Guidance” that will help the borrower “naturally” be able to make the monthly payment, without “bailout” or extensive loan mods which have proven to be a failure.

    Prof. Samuel D. Bornstein
    [email protected]

    • Richard Schulz on

      How about back to commen sense underwriting, would this not be enough? 50% DTI on the front end are a bit rediculous are they not? How about some control on credit cards issued because someones credit score is high. I am sure that we will see tremendous changes in credit guidlines, I believe it will last for 4 years and then…Like this whole situation never happened, it will be repeated once again, thats the nature of Man!

  3. I actually have a solution which actually could really help MANY people out. If more states would allow Real Estate Raffles for charity to exist legally then everyone could benefit involved. The bank would get the loan paid, the home owner would sell the house for market value and a charity would bring in revenue for their cause. The idea really works. You can find out more information here at http://reraffle.com

  4. Your argument would hold water if the banks were not getting help.
    Leaving the situation “as is” and pretending that banks are now being smart is giving the systemic cancer that got us there in the place profitable in the long run, therefore, why not do it again?
    After all, the losers will always be at the bottom of the chain, and banks will simply have to ask for temporary help from the federal reserve.

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