Who's to Blame for the Mortgage Mess?

Banks and mortgage servicers have been scolded and screamed at -- to the point of being threatened with fines -- for not making enough mortgage modifications permanent. This makes for great stress relief, but few have answered why the government's $75 billion mortgage modification plan has started off with a slow, sad, whimper.

Just how bad is it? Through November, an embarrassing 4% of trial modifications -- a multimonth let's-see-if-you're-really-worthy test -- were made permanent. That's pitiful.

More frustrating, the biggest banks are moving at a pace that's comically close to zero:

Sources: financialstability.gov, author's calculations.

Now, trial modifications have a three- to five-month audition period before they become permanent. So to get a better measure of the true success rate, we have to compare current permanent modifications to trial modifications issued in previous months. Current permanent modifications as a percentage of July's trial modifications shows a 12% success rate. That's better than the 4% headline number, but should still make you sick.

Looking for heads to roll
Who's to blame here? When in doubt, it's routine to blame the banks. Just ask Goldman Sachs (NYSE:GS). But instead of jumping to conclusions, we need to know what's happening behind the scenes, after trial modifications are granted.

Thankfully, JPMorgan Chase recently gave an investor presentation outlining just that. For every 100 trial modifications offered, here's what it found:

• 29 customers do not make required payments
• 71 customers make all three required payments
• Of those 71 customers, 51 do not submit all documents required or submit documents that require refinement for underwriting

Ouch. Only about 20% of borrowers carry out their half of the deal. If JPMorgan is indicative of the industry, it's the borrowers, not the banks and servicers, who should be blamed for the low success rate. And because the problem lies with unqualified borrowers -- not inefficient servicers -- it's reasonable to assume the success rate won't go appreciably higher than it currently is.

What's that mean for the housing market? As of November, there were 728,408 active trial modifications. Because most of those borrowers won't be granted permanent modifications, many will end up defaulting. That means a slug of potential foreclosures are currently being held off the market thanks to trial modifications, but will likely face default sometime next year.

Knowing this might rain on recent news that foreclosures are beginning to wane. According to RealtyTrac, November foreclosures fell 8%. That's wonderful, but the gain is almost certain to reverse once failed trial modifications are purged. Indeed, RealtyTrac notes that the decrease in foreclosure filings was thanks to "loan modifications and other foreclosure prevention efforts." That's awesome for the time being, but useless if those prevention efforts aren't made permanent.

Where to now?
How big an impact have trial modifications had on foreclosures? One way to gauge is to compare the number of foreclosures with the number of newly issued trial modifications:

Sources: RealtyTrac, financialstability.gov, author's calculations.

*May and prior.

That's ugly: The monthly number of trial modifications issued far exceeds the month-to-month decrease in foreclosure activity. When you think about the success rate of trial modifications, this isn't an insignificant fact to ignore. And it all leads to three conclusions:

• The recent decrease in foreclosures has largely been caused by trial modifications.
• Most trial modifications won't be made permanent.
• 2010 could be a year of uncomfortable surprises.

What do you think? Do you see signs of a sustainable real estate recovery in your neighborhood? Let me know in the comments section below.