The Biggest Failure of the Year

Government officials patted themselves on the back last week, announcing that the mortgage modification plan implemented earlier this year through Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) is totally, 100%, killing it.

More than 500,000 mortgages are now in a trial modification plan, one month ahead of the half-a-million goal marker. "We believe we are absolutely moving in the right direction and have reached an important turning point in our modification effort," said Housing and Urban Development Secretary Shaun Donovan.

Great success!
These numbers might look encouraging. Struggling homeowners are getting aid. Expensive mortgages are being reduced. Bubbles are being slain. Help has arrived.

But remember the old saying, Fools: quality over quantity.

One week before the government praised itself for the volume being cranked out, it released a report showing just how these modifications are performing.

As was the case earlier this summer, mortgage modification re-defaults -- modified loans that fall back into default -- are quite high. And not just a little high ... not just annoyingly high ... but horrifyingly high:

Source: Office of Thrift Supervision, Office of the Comptroller of the Currency, September 2009.

Within three months of modification, more than 40% of borrowers found themselves back in delinquency.

Now, I know what you're thinking: OK, but that's just the 30-day delinquency rate. How about longer-term, actual defaults? It's just as scary:

One year after modifications, about half of borrowers are more than 90 days past due -- usually the barrier where a lender considers the loan a lost cause. I can't think of many things in life with a 50% failure rate that can be considered anything but failures.

What went wrong?
The reason re-defaults are such a problem is simple: Modifications aren't targeting the right issue.

Continuing with our parade of government reports, the Congressional Oversight Panel just released more data on these modifications. Among its findings: The loan-to-value (LTV) ratio for average modified mortgages actually increased during the modification process. Before modifications, average LTV ratios were 134%. After modifications, the average was 137%.

This is because 64.3% of all modifications simply capitalize late payments and fees onto the existing balance. That's actually a big negative for the one-third of homeowners who are underwater, since the modification actually strengthens the incentive to walk away from their home.

More than 70% of modifications also included interest rate reductions. This is helpful for some with adjustable-rate mortgages, but it doesn't do anything for those whose mortgages aren't just resetting to higher interest rates, but recasting to higher payment schedules. In one extreme example, Bloomberg talks about a borrower whose adjustable-rate mortgage payment could jump from $98 a month to $3,500 a month. Such moves have less to do with higher interest rates than they do with payments resetting to sensible amortization schedules. More specifically, people in these situations bought homes they could never afford, and no modification will really help. That's an unfortunate but realistic truth.

Not biting the bait
If there's one bit of good news, it's that banks haven't been ambitious with modifications:

Source: U.S. Treasury.

This is only encouraging because banks can often recover more money by foreclosing quickly, rather than granting a modification with a 50% failure rate, and inevitably foreclosing on a house that likely lost value during the modification trial period.

I'm all for helping those in need. But the mortgage modification plan helps such a small percentage of those intended that we have to wonder how much help, overall, it's really providing. Especially when you consider that the taxpayers it's designed to help are also footing the bill.

Maybe you disagree. Have a positive mortgage modification story to share? Feel free to share it in the comment section below.