In the past, a traditional mortgage lender would decide whether to foreclose or restructure a defaulted loan based on a cost-benefit analysis of available options. If the lender stands to make more money by modifying a loan than the lender would make on the home through a foreclosure sale, the lender would generally choose to modify.
In today’s housing market, most residential mortgage loans are not owned by traditional lenders. The mortgage loans are securitized. Securitized mortgage loans are managed by third-party mortgage servicers as agents for mortgage-backed securities (“MBS”) investors. The investors do not play a role in the loan modification decision making process.
The method by which mortgage servicers are compensated creates a principal-agent conflict between them and the mortgage investors. Servicers have no stake in the performance of mortgage loans. The servicers have no interest in maximizing the net present value of the loan. Instead, servicers’ decision of whether to foreclose or modify a loan is based on their own internal cost benefit analysis. The method by which services are paid, favors foreclosures. In many cases, a mortgage servicer will make more money on a foreclosure than a loan modification. The costs of this principal-agent conflict are thus placed directly on homeowners with securitized loans.