Housing Fix's Challenge: Making Modified Loans Attractive

By RUTH SIMON

The Obama administration's housing plan, set to be rolled out Wednesday, will have to reckon with a little-understood fact underlying current efforts to slow foreclosures: More than half of mortgage modifications have left borrowers with the same or higher loan payments.

While modifications are designed to keep owners in their houses, by the time they are worked out, borrowers often are well behind on their loans. Lenders often add these past-due amounts -- which can include principal, interest, taxes and insurance -- driving monthly payments higher. At the same time, lenders have been reluctant to reduce principal even for borrowers who owe far more than their homes are worth.

Higher loan payments may make sense in limited cases, but they increase the likelihood of the modification failing, critics say. "If you restructure a loan so that people pay the same or pay more, it's probably not going to work," said Iowa Attorney General Tom Miller.

Thirty-eight percent of recent loan modifications resulted in increased payments for borrowers, according to an analysis by Alan M. White, a professor at Valparaiso University School of Law in Indiana, while 13% resulted in no change to payments. The study looked at more than 23,000 modifications between Dec. 26, 2008, and Jan. 25, 2009, involving subprime mortgages and Alt-A loans that were packaged into securities.

Mortgage servicers try to structure payments so they are affordable to borrowers, said Jay Brinkmann, chief economist of the Mortgage Bankers Association. Where payments rise as a result of modifications, he says, the increases are often modest.

There are some signs mortgage companies are becoming more aggressive when helping troubled borrowers. Twelve percent of recent loan modifications included some forgiveness of principal, interest and fees, according to Prof. White, compared with 10% in November and 2% between July 2007 and June 2008.

Still, the lack of payment relief may help explain why so many borrowers are falling behind. Forty-nine percent of borrowers redefaulted within six months after receiving a modification that increased their principal and interest payments by 10% to 20%, according to ratings company Fitch, compared with a 21% redefault rate for borrowers who saw their payments fall by 20% or more.

Loan modifications that result in higher payments can be attractive to mortgage companies, analysts say, in part because they aren't likely to attract the ire of investors who purchased mortgages that were packaged into securities.

Linda and Donald Michael Walrad, who live in Osceola, Iowa, are among the many homeowners who faced an increase in monthly payments. After the couple fell behind on their mortgage, Countrywide Financial Corp., which was acquired by Bank of America Corp. last year, offered to reduce the interest payment on their loan for two years, while boosting their loan balance by roughly $11,000 to about $85,000.

A Countrywide spokeswoman said that to provide borrowers with a clean slate, the company will capitalize past-due interest amounts, including interest and taxes, and in some cases will use an escrow account to begin collecting for future taxes and insurance.

The Walrads, who also needed to do work on their home, turned down the bank's offer, which would have boosted their monthly payment to $704 from $665. Countrywide's offer "wasn't any relief at all," said Ms. Walrad.

Some modifications result in payments staying the same because they simply involve freezing the borrower's interest rate. The federal government has encouraged mortgage companies to provide such rate freezes to subprime borrowers who are current on their loans but are likely to fall behind once their interest rates reset.

Thomas Kelly, a spokesman for J.P. Morgan Chase & Co., said that "until very recently, some of our major investors required us to capitalize past-due payments and then re-amortize the loan."

Large mortgage servicers run borrowers through affordability tests before offering a modification, said Bank of America mortgage-servicing executive Steve Bailey. But mortgage companies also have to consider what is best for investors who bought mortgage-backed securities, he said. Providing more concessions to borrowers may lower redefaults but result in greater losses to investors than less aggressive modifications, he said.

"We hope the administration will make an announcement that addresses that challenge," Mr. Bailey said.

Write to Ruth Simon at ruth.simon@wsj.com