Abstract

The number of modifications to distressed residential loans following the 2008 financial crisis has been disappointingly low compared to the number of foreclosures. This raises concerns about the presence of artificial barriers to loan modifications in situations where foreclosure should be avoidable. There are three pressing reasons to care about what the real barriers to foreclosure prevention are. First, foreclosures that could have been avoided inflict enormous, needless losses on borrowers, investors, and society at large. Second, overcoming artificial barriers to foreclosure prevention will result in loan modifications with higher rates of success. Finally, knowing what to fix is necessary to identify the right policy solution.

Numerous theories have been advanced for the relatively low level of modifications, including: restrictions on loan modifications in private-label servicing agreements, threats of lawsuits by private-label investors, servicer compensation arrangements, the high cost of loss mitigation, accounting rules, junior liens, and tax considerations. This Article concludes that servicer compensation coupled with the costly nature of loan workouts, accounting standards, and junior liens form the biggest impediments to an efficient level of loan modifications. These factors also tilt the mix of loan modifications toward types of modifications with higher redefault rates. Other explanations, such as servicing agreement restrictions, tax consequences, and the threat of lawsuits, are either not at play or are of second order importance.

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