Barriers to Foreclosure Prevention During the Financial Crisis

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.