Loan modifications have been big news (not all good) over the past few years as the government has fully instituted the Home Affordable Modification Program (HAMP). Although HAMP has thus far been an unmitigated failure, it was originally intended to provide financial incentives for lenders to lower interest rates, extend maturity dates and reduce principal so that financially troubled borrowers could afford their mortgage payments and stay in their homes. What we have seen, however, is that of the very small number of borrowers who actually receive a loan modification, more than 60% re-default within 1 year.
What's the problem?
Traditional modification methods only focus on interest rate reductions and term extensions while almost completely ignoring principal balance reductions (i.e. lowering the amount owed on the loan). This approach simply fails to address the borrower's lack of equity or the long term sustainability of the loan modification. Principal reductions are the key to a successful loan modification, but we know that they are going to be the rare exception to the rule.
Why? Three words: Net Present Value.
A common refrain among borrowers facing default and seeking a loan modification is the following: "Why doesn't my lender just reduce my loan balance to the current market value? They aren't going to get any more than that at a foreclosure sale." While it is absolutely true that a lender can only obtain current market value if it forecloses and sells the property (in fact they will probably get LESS), this argument ignores the complex financial analysis that the servicer (that's the company responsible for collecting payments and reporting to the lender) must complete to make sure they are limiting the loss to the lender. The servicer MUST select the option which provides the highest recovery to the lender by using the NET PRESENT VALUE TEST.
In simple terms, if the lender reduces the loan balance to the current market value, they are stuck with 30 or 40 years of payments based upon that lowered loan balance (and possibly at a much reduced interest rate). However, if they foreclose and sell the home, they get that money (less costs) RIGHT NOW. Lenders understand that receiving a lump sum of money today is far more valuable than receiving that same amount of money over the course of 30 years or more along with the added risk of re-default. In fact, it is possible that a lender could receive LESS THAN current market value through foreclosure but still realize a HIGHER NET PRESENT VALUE by getting that money immediately as compared to taking payments over the life of the mortgage. Therefore, a foreclosure almost always generates a higher NET PRESENT VALUE for the lender as compared to a loan modification with a significant principal reduction.
So, if a servicer is obligated to limit the loss to the lender, they are simply unable to offer a loan modification if a foreclosure would generate a higher Net Present Value for the lender. Therefore, the servicer CAN'T offer, and the lender WON'T accept, a loan modification. The home will be forced through foreclosure.
In Part 2 of this article, I will give a detailed explanation of the TWO PART loan modification test and how NET PRESENT VALUE affects whether your loan modification is approved or rejected.
Derik N. Lewis assists clients (both lenders and borrowers) in resolving troubled real estate loans. his company Lawyers Realty Group advises on real estate workouts involving complex loan restructuring, forbearance, foreclosure, short sale and other recovery and/or disposition options. Derik also has substantial experience representing real estate investors in the purchase and sale of distressed and non-performing loans along with the acquisition of troubled real estate assets.
Prior to becoming an attorney, Derik was a real estate consultant for regional and national real estate companies such as Trammel Crow, Related Companies, and Balcor/American Express. In that capacity, he provided short-term management services for large residential apartment properties that were experiencing management transitions during rehabilitation or renovation or while under contract for sale.
Derik graduated magna cum laude from Boston University School of Law and was named both G. Joseph Tauro Distinguished Scholar and Paul J. Liacos Distinguished Scholar for his academic accomplishments. He is licensed to practice law in the state of California and is also a licensed California real estate broker & Realtor�.
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