Santa Clara University

 Troubled Home Loans

What’s The Most Effective Way to Modify Them?


    Following the recent crash of the housing market, lenders have actively been restructuring and modifying home loans to avoid foreclosures as much as possible. Professor Sanjiv R. Das, chair of the Finance Department in the Leavey School of Business, has looked at the way they’re doing it and concluded that the current approach may be suboptimal.

    “In an attempt to make loan service affordable for a borrower, lenders are usually reducing monthly payments by reducing interest rates, extending the term of the loan, or some combination of the two,” Das says. “The subsequent re-default rate is very high, ranging from one-third to two-thirds of modified loans, depending on how you look at it. Lenders may be doing exactly the opposite of what’s theoretically indicated.”

    Lenders, he says, may not have properly accounted for the willingness to pay. Simply put, a borrower in trouble, particularly a borrower with negative equity, has the option of turning over the keys and walking away from the home and the loan. A loan modification that doesn’t provide some incentive not to do that carries a higher risk of re-default.

    Das says that earlier this year a student put him in touch with a man who was making that argument, and Das decided to create a mathematical model to test that hypothesis. The result of his research is contained in a paper, “Saving Homes and Banks: Optimal Modification of Distressed Home Loans,” that is about ready to be submitted for publication.

    What would make far more sense than cutting interest rates or extending the term of the loan, he found, would be writing down the principal on the loan. That immediately gives the borrower more equity and a greater incentive to remain in the home and continue to pay off the loan.

    Banks and other lenders are reluctant to do that, Das says, because of the initial financial hit they have to take. Yet if they end up foreclosing on a house and reselling it, they’re likely to lose about 30 percent of the property’s value and create a ripple effect that adversely affects the value of neighboring properties on which they’ve loaned money.

    That “deadweight loss” is something banks and other lenders want to avoid, and one way of doing it would be to write down the loan in stages so the lender doesn’t take the full force of the financial hit up front.

    Interestingly, Das says, while most lenders have so far been reluctant to adopt this approach, a number of hedge funds that buy securitized mortgages have done exactly this, something they can more easily do because they’ve bought the loans at distressed prices.

    Recently Das was on the East Coast presenting his model to banks and regulators who are receptive to his ideas. “They recognize that the lowest economic loss over the remaining life of the loan is likely to occur if they write down some of the principal,” he says.

    Borrowers are increasingly aware that they have a valuable option to default and are less reluctant to walk away from a loan that no longer works for them.

    “There are two factors that come into play in restructuring a loan,” Das says, “the ability to pay and the willingness to pay. The social stigma of foreclosure has all but gone because there have been so many foreclosures that no one cares any more. What was not recognized by lenders in the past was the value of the borrower’s option to walk away from the loan.”

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