'Mass Mods': Will Help for Homeowners Be Enough?

All the programs for troubled borrowers offered by banks and government may not be enough to stem the tide of foreclosures

The mass efforts to modify mortgages and stave off foreclosures sound great. JPMorgan Chase (JPM) is reaching out to 400,000 at-risk customers. Fannie Mae and Freddie Mac are freezing foreclosures until 2009. Some 500,000 distressed borrowers at Citigroup (C) could get relief over the next six months. But even if banks live up to their promises, the initiatives may not be the panacea the housing market needs.

Following the lead of state and federal agencies, many of the industry's biggest lenders have announced plans in recent weeks to work out troubled mortgages by cutting rates, deferring principal, or extending the lengths of loans—all designed to lower borrowers' monthly payments and keep people in their homes. But absent further steps, the private and public programs together will help only about 2 million homeowners, fewer than a quarter of the borrowers expected to face foreclosure through 2010. Those tallies could rise if unemployment, now around 6.5%, climbs above 8%.

Not all borrowers should be saved. After all, some foreclosures are important to rid the market of people who should never have gotten a loan in the first place. Also, real estate speculators, individuals who bought a second or third home, and dubious borrowers aren't likely to get relief.

A necessary purge aside, the outlook isn't pretty. If banks do manage to prevent all 2 million foreclosures, the number of homeowners who default each year will still be four times higher than earlier this decade. It's hard to stabilize home prices when defaults are hitting records. The programs "are just a drop in the bucket," says John H. Maher at banking consultancy LECG (XPRT).

Despite the grand gestures, banks face hurdles in reworking loans en masse. Lenders can easily revamp the mortgages they own outright on their books, but they don't always have the authority to change loans sold to investors in mortgage-backed securities.

The legal battles could start soon. BusinessWeek has learned that a prominent money management firm plans to file suit in early December against one of the nation's largest banks over the bank's loan-modification program. The firm alleges the bank won't absorb the losses from cutting mortgage payments, passing them off instead to investors.

It may also take a while for banks to kick their programs into high gear. Consider AIG Federal Savings Bank. As part of a 2007 agreement with its regulator, the Office of Thrift Supervision, over predatory lending practices, the unit of insurer AIG set aside $178 million to bail out borrowers. Some 18 months later, the thrift has refunded only $48.4 million in fees, according to regulatory filings. AIG Federal Savings has also cut the overall size of its program by $53 million, leaving just $76.6 million to modify loans. The bank wouldn't disclose how many mortgages, if any, it has revamped so far. "AIG Federal Savings Bank [and an affiliate] have provided relief for thousands of customers consistent with the terms of the [regulatory] agreement," says an AIG spokesman. OTS officials say the program is working.

MANY BACKSLIDERS

Meanwhile, there's no guarantee that troubled borrowers who get a new loan won't become repeat offenders. Most of the new plans lower a homeowner's monthly mortgage bill to 38% or 40% of their aftertax income. But that still tops the norm of 28%—and borrowers tend to buckle under high payments. Historically, roughly 50% of modified mortgages sour after a few payments, according to Lender Processing Services (LPS), a Florida loan-processing firm.

A JPMorgan spokesman notes that of the 400,000 borrowers flagged for loan modification under its new program, some 40,000 have already been bailed out by the bank at least once during the past two years. Says Mark Fleming, chief economist at First American CoreLogic (FAF), a mortgage industry consultant: "Loan-modification programs have a high recidivism rate." That suggests the hangover from the housing bust could last for quite a while.

With Brian Grow in Atlanta and Mara Der Hovanesian in New York