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FINANCIAL CRISIS INQUIRY COMMISSION REPORT
For them, foreclosure is a prudent response to default because, the data suggest,
many borrowers who receive temporary or permanent forgiveness on their terms
will slide into default again. Also, servicers may receive substantial fees for guid-
ing a mortgage through the foreclosure process, creating an incentive to deny a
modification.
Frequently, there’s another complication to attempting a foreclosure or modifi-
cation: the second mortgages that were layered onto first mortgages. The first
mortgages were commonly sold by banks into the securitization machine. The
second mortgages were often retained by the same lenders who typically service
the mortgage: that is, they process the monthly payments and provide customer
service to borrowers. If a first mortgage is modified or foreclosed on, the entire
value of the second mortgage may be wiped out. Under these circumstances,
the lender holding that second lien has an incentive to delay a modification into
a new loan that would make the mortgage payments more affordable to the
borrower.
The country’s leading banks now hold on their books more than billion in
second mortgages. To the extent the banks have reported these loans as performing,
the loans have not been marked down on their books. The actual value of these sec-
ond mortgages could be much less than their billion-plus reported value. The
danger of future losses is self-evident. Some frustrated first-lien investors have sued
servicers, asserting they are not protecting investors’ financial interests. Instead, they
claim that because the servicer is holding the second lien, the servicers are looking
after their own balance sheets by encouraging borrowers to keep up the payments on
their second mortgage when they cannot afford to make payments on both obliga-
tions. According to Laurie Goodman, for mortgage modifications to work, the hold-
ers of the second mortgages will have to accept some losses—a potentially expensive
proposition.
A number of other obstacles have made modifications difficult. For example,
there are competing interests among various investors in a mortgage-backed security.
Proceeds from a foreclosure may be enough to pay off the investors holding the high-
est-rated tranches of securities, while the holders of the lower tranches would likely
be wiped out. As a result, the holders of the lower-rated tranches might prefer a mod-
ification, if it produced more cash flow than a foreclosure.
Other efforts in the private and public sectors to address the foreclosure crisis
have focused on encouraging short sales. In theory, short sales should help borrow-
ers, neighborhoods, and lenders. Borrowers avoid foreclosure; neighborhoods
avoid vacant, dilapidated homes that encourage crime; and lenders avoid some of
the costs of foreclosure. Nonetheless, such deals frequently stall because the process
is cumbersome, demands coordination, and eats up resources. For example, lenders
can be reluctant to sign off on the buyer’s bid because they are not sure that the
home is being sold at the highest possible price. In addition, when there are two
mortgages, the holders of the first and second mortgages must both agree to the
resolution.
