Loan modifications are rarely granted because foreclosure is a quicker and often more lucrative remedy for lenders. The borrower needs to put together an appealing package for the lender to consider for their loan modification to be approved. Temporary financial hardships are far more appealing to lenders than permanent or long-term changes in financial prospects.

Furthermore, the borrower often lacks the cash flow necessary to support reduced payments, let alone the initial payments. Also, the appraised value of the property may fall below the loan to value ratio, thus making refinancing even more unappealing to lenders.

Who Approves Loan Modifications?

Loan modifications are processed and approved by the mortgage loan servicers. Especially the loans that have been securitized. In the securitization process the mortgage servicer is given the authority to negotiate and approve loan modifications for borrowers in need. As part of the securitization process most if not all of the securitized loans were insured through Credit Default Swaps.

What is a Credit Default Swap?

Similar to PMI, Credit Default Swaps (CDS) are a type of insurance paid out to the investors if the borrower defaults. Depending on the loan modification, this “default insurance” can be voided by the insurance companies. The insurance becomes voided because the insurance companies view material changes to the loans (interest rate, principal amount, time) as creating new loans that are no longer insured for default, placing full weight of the losses on the investors. As we all know insurance companies look for any excuse to avoid paying on their policies. The only thing that guarantees payment on the policy is foreclosure of the property. Which is why in some cases, the servicers are more amenable post foreclosure then they were before foreclosure, sometimes.

Loan Modifications Effect Taxes for Lenders

Loan Modifications also impact certain IRS rules for these securitized mortgage entities called REMIC’s. The loan modifications are viewed as new loans that violate the terms of the pooling and security agreement resulting in voiding the special tax-free privileges these investors receive. Essentially these entities avoid paying taxes on billions of dollars of interest payments collected every year from borrowers.

Loan modifications, deed’s in lieu, principal reductions, and short sales alter the terms of the original mortgage with the borrower and can be interpreted as canceling the previously tax exempt and insured transaction into a taxed, and uninsured transaction. The losses can be monumentally staggering to the investors who purchased these mortgages on the secondary markets.

Now there are exceptions and some loan modifications are approved, however the percentage of loan modifications requested versus the number approved is minimal. Less than 5% of all loan modifications are approved.

Loan modifications are discretionary. Despite the implementation of programs such as HAMP and HARP, there is still little pressure on lenders to enter into loan modification discussions.