The word of the day is re-default:

Comptroller of the Currency John C. Dugan said today that new data shows that more than half of loans modified in the first quarter of 2008 fell delinquent within six months…

A key question, Mr. Dugan said, is why is the number of re-defaults so high? “Is it because the modifications did not reduce monthly payments enough to be truly affordable to the borrowers? Is it because consumers replaced lower mortgage payments with increased credit card debt? Is it because the mortgages were so badly underwritten that the borrowers simply could not afford them, even with reduced monthly payments? Or is it a combination of these and other factors?”

An even more key question is why on earth Mr Dugan is surprised by this number. As Paul Jackson points out, loan mods normally have a 50% failure rate. On top of that, there are two key points which Dugan seems to have missed:

  • The single most important factor underlying mortgage defaults is falling house prices.
  • House prices have continued to fall throughout 2008.

Given all that, we should be thankful that loan modification programs have managed to keep half of formerly-delinquent homeowners out of default.

We should also understand why, from a bank’s point of view, it’s silly to modify loans by reducing the principal amount outstanding. It makes sense to reduce interest payments — to something well below the bank’s own cost of funds, if necessary. But the bank will also want to protect itself if that doesn’t work, by keeping the total amount owed high. The problem there is that the homeowner will remain underwater — and having an underwater loan is a strong incentive for any homeowner to walk away.

As ever, there are no easy answers. But maybe it really takes a year’s worth of re-default data to persuade the OCC of that.

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