Foreclosing Modifications: How Servicer Incentives Discourage Loan Modifications

Despite record losses to investors, homeowners, and surrounding communities, the foreclosure crisis continues to swell. Many commentators have urged an increase in the number of loan modifications as a solution to the foreclosure crisis. The Obama Administration created a program specifically designed to encourage modifications. Yet, the number of foreclosures continues to outpace modifications.

One reason foreclosures outpace modifications is that the mortgage-modification decision maker’s incentives generally favor a foreclosure over a modification. The decision maker is not the investor or the lender, but a separate entity, the servicer. The servicer’s main function is to collect and process payments from homeowners, and servicers do not necessarily have any ownership interest in the loan. Servicers, unlike investors, generally recover all their hard costs after a foreclosure, even if the home sells for less than the mortgage loan balance.

Servicers may even make money from foreclosures through charging borrowers and investors fees that are ultimately recouped from the loan pool. Existing regulatory guidance could be improved to facilitate modifications. Investors need increased transparency to hold servicers accountable for failing to make modifications when it is in the investors’ best interests to make modifications. Fundamentally, servicers must be required to make modifications when doing so would benefit the trust as a whole.