Modifying mortgages is incredibily difficult (reducing interest rate, short sale, principal forgiveness, etc.).
Here are a few scenarios:
Traditional Mortgage
If a foreclosure process would net out less than a short sale and the bank was convinced the homeowner could not pay the current mortgage, the bank would accept the short sale. The homeowner would need to show they cannot pay the current mortgage by missing payments (but can trash the borrower’s credit score) and could hurt prime borrowers, especially.
Mortgage + Home Equity Line of Credit (HELOC) Scenario
Complications can arise with a HELOC involved. Two lending institutions must approve the short sale for it to occur. If the value of the home drops below the value of the primary mortgage, the HELOC owner’s default behavior would be to veto a short sale, as the second lien holder would not receive anything. If the short sale is better than foreclosing the primary mortgage owner, then the primary mortgage owner may sweeten the deal to the HELOC by offering some payment to allow the short sale to complete.
Securitized Mortgage
The purpose of securitizing a mortgage is that they can be sold to investors. This in turn allows the bank to turn around and lend even more money. When securitizing a mortgage, strict rules about what modifications and under what circumstances are written in a security contract. Modifications to securitized mortgages become a matter controlled by contract law.
Collateralized Debt Obligation (CDO)
The CDO pooled subprime securitized mortgages and divided them into slices or subgroups. For example, if there are 10 slices (tranches), then it is like dividing the mortgages into a first, second, third and so on till the 10th mortgage. The first mortgage gets their money back before any of the others, so it is much safer than the 10th position mortgage. The first few tranches would get a high credit rating because the losses would be seen at the bottom of the “tranches” or slices.
The first place tranche is secure since they will get their money back and have no desire to lower the rate. Meanwhile the lower tranches desperately want to avoid being pushed into foreclosure, and would rather make an interest rate modification than lose their principal from foreclosure.
CDO Squared
No one usually wants to buy the lower rated tranches of the CDOs, so they’ve collected those together and pooled them together and sliced them into tranches. And through faulty statistics, they were able to get higher tranches high credit ratings again.
Credit Default Swaps (CDS)
These are derivatives that act like insurance contracts on a credit obligations. The onwer of a mortgage backed securities may decide to buy credit default swaps on some of them to reduce their risk (instead of selling the mortgage back securities). These CDSs are bought and sold all the time.
The Result
Many interested parites are pulling in different directions and are willing to sue the servicer if modifications are made outside the guideline written into the security. The servicer is generally constrained by what the contract allows them to do. The government can provide some liability cover here for servicers and work on loans owned by Fannie and Freddie, but they still have to walk a fine line to not impringe on contract law too heavily.
The government’s efforts may slow down the rate of foreclosures to keep home prices from falling even further and faster than otherwise, but there is just too many people with too much house. So slowing down the foreclosures, means the housing problem will last much longer than expected.