When I talk to homeowners I know about their problems getting a loan modification or when I work on a short sale, a common theme that comes up over and over again is “Why is this process so hard if the bank is going to lose more money on foreclosure than they will on a loan modification or short sale?”
Implicit in this question are two assumptions:
- That there’s “the bank”, someone who owns the loan and stands to lose if it isn’t paid.
- That “the bank” is controlling whether some kind of modification / sale goes through or whether you go into foreclosure.
The reality is much more complex than this. A far more likely scenario is that there are several parties involved here, not just you and the bank. Most likely the people involved in your loan include:
- The bank or mortgage broker that originated the loan, who may now be irrelevant because they’ve sold the loan to someone else.
- A loan servicer, which often is a mortgage bank or a company with a business relationship with one or more mortgage banks. These are the people responsible for collecting your payment, and who will foreclose on you (or not).
- Any number of intermediate entities through which the loans were aggregated in a pool of mortgage and “securitized”, i.e., converted into one form or another of a mortgage backed security that can be sold to investors.
- The investors who have purchased the mortgage backed security that includes your loan.
Who Wins and Who Loses?
Remember our original assumption about “the bank”? Well, there isn’t one.
When you say that “the bank” will lose if they foreclose, what comes closest to the truth is that the investors who hold the mortgage backed security will lose. The problem is this: the servicer stands to gain more and lose less if you go into foreclosure than if your loan is restructured in any way that’s going to really help you.
Why Servicers Prefer Foreclosure
The main source of a servicer’s income is a percentage based on the current principal balance of the loan. For prime loans this might be 25 basis points (i.e., 25/100 or 1/4 of one percent). For subprime loans it might be higher, up to 50 basis points. So the higher your principal balance, the more money they make.
Now, if the loan is modified in such a way as to reduce the principal, the servicer loses. They’re still paying the investors their full payment while this is being negotiated, and they’re having to borrow money to do that. Now just like you, part of their “credit score” is based on how much debt they have already. Probably because of this, credit rating agencies rate them higher if they move people to foreclosure quickly.
Moreover, once the loan is modified, servicers typically have to wait to be reimbursed for whatever expenses they had to be paid to them.
So in the case of a loan modification, the servicer has to borrow money, is losing money while the loan modification happens, and has to wait to recover that money when the modification goes through. Now let’s look at what happens in the case of foreclosure. The servicer loses an income stream on your principal balance here of course, but the foreclosure sale generates cash.
Guess who’s first in line to receive this cash? Is it the investors who own the loan? No, it’s the servicer. Out of the cash from the sale a the servicers get a hefty fee for doing the foreclosure. Moreover, the servicer recovers whatever late fees and penalties they assessed you along the way. (Now I know why servicers will advise borrowers in trouble to pay late — the servicers will then get paid more when they foreclose!). They also get reimbursement for services they’ve purchased such as broker price opinions (BPOs). When they charge these services against the cash from the sale, they’ll often mark up the services, so that (for example) the $50 they paid fora BPO turns into a $125 BPO that the investors pay for.
All of this is paid out to the servicer first, then the servicer sends whatever’s left to the investors.
That Sick Feeling You Have Now Is Normal
If you’re feeling sick to your stomach that this is how the system works, I’m with you. How about some nice protest music to cheer us up? Here’s Pete Seeger doing “The Banks Are Made of Marble”, with suggestions for further reading (the articles on which this was based) below.
This article was based in large part on a much more detailed treatment of these issues in a Background Paper done by the California State Assembly. I highly recommend this article. To a lesser degree I also consulted one of the articles cited in that paper, The National Consumer Law Center’s Why Servicers Foreclose When They Should Modify and Other Puzzles of Servicer Behavior.
This is serious wonk stuff. Pete Seeger is much more accessible if you’re in a hurry.