Published 12-28-2010 in the Arizona Journal of Real Estate & Business.

BANKS & FORECLOSURES

Nagle Law Group

Why Do Banks Foreclose Rather Than Modify Home Mortgages?

It does not seem logical that a bank would prefer to foreclose on a mortgage, rather than modifying it. After all, once the bank forecloses it must then find a buyer for the house which can be extremely difficult in today’s housing market. Furthermore, until a buyer is found the bank must maintain the home (mow and water the lawn, trim the trees, etc.), pay the real estate taxes, the homeowners association fees and the homeowners insurance. Even if a buyer purchases the house at the foreclosure sale, lenders typically receive 34% fewer dollars versus “short-sale” transactions.

A prime reason that modification is not the preferred method to resolve today’s mortgage mess involves the role of the mortgage loan servicer. In most cases the original lender (or the investors to whom the original loan is sold) hires a loan servicer to collect the monthly mortgage payments. It is the loan servicer who deals with the homeowner’s request to modify the mortgage. The sad truth is that there are more powerful incentives for the loan servicer to favor foreclosure rather than modification. Some of these incentives are:

• a loan servicer’s fees are generally based on a percentage of the principal balance of the loan – modifying the loan by reducing the principal would therefore reduce the loan servicer’s fees.
• late fees and other default-related charges are a prime source of loan servicers income; thus loan servicers are rewarded for keeping a borrower in default.
• the loan servicer also collects its late fees and default charges from the proceeds received at the foreclosure sale before the investor sees any money.
• complicated tax and accounting rules, although not outright prohibiting loan servicers from making modifications, generally discourage them in favor of foreclosure.
• the upfront fees in pursuing loan modification, such as additional staff and other overhead costs, can be costly to the loan servicer.

 

Although there are a myriad of additional reasons why loan servicers favor foreclosure, the ugly truth is that loan servicers potentially profit from a foreclosure, but almost always lose money from a loan modification. It is not difficult therefore to understand what at first blush seems illogical – foreclosure is more costly to everyone involved in the process, yet foreclosure is the more common outcome for the underwater mortgage.

Clearly, the current patchwork system of weak government and lender sponsored programs to address the existing mortgage crisis is not working. Underwater homeowners are walking away from their mortgages or their lenders are foreclosing. The solution that would be in everyone’s best interest, namely meaningful loan modification via principal reduction, is just not happening. Much more can be done to increase the likelihood that loan modification will be favored over foreclosure including strong legislation mandating that loan modification be seriously considered by the servicers before foreclosure, changes to tax and accounting rules, court sponsored mortgage mediation programs and caps on default related charges.

Stuart Pack is a partner with Nagle Law Group, P.C., focusing on residential transactional and debt management matters, and can be reached at 602-595-3156 or stuart.pack@naglelaw.com.