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203 The implosion of the subprime market in early 2007 and subsequent deterioration of the prime market in 2008 caused by the rapid rise in mortgage defaults resulted in significant media and political focus on saving homeowners from foreclosure and the possible loss of their home. Although the default problem in the prime segment of the market is less severe, the issues related to keeping borrowers in their homes affect all market segments, not just subprime loans. In particular, what do we know about defaults and what causes them? Is there an ideal cost-benefit time frame for the foreclosure process? What are the costs of foreclosure? Where will the next gains in default servicing come from to maximize the potential for borrowers to keep their homes? This chapter examines these issues, focusing on the prime side of the market and in particular prime conventional (that is, not government insured) and conforming (meeting the underwriting guidelines of Freddie Mac or Fannie Mae) Interventions in Mortgage Default: Policies and Practices to Prevent Home Loss and Lower Costs amy crews cutts and william a. merrill 7 The authors are grateful to Jimmy Cheng, Shawn Connell, Steven Geyer, Nathaniel Hoover, Sandy Sweeney, and Robin Toothman for their research assistance, and Bob Kimble and Calvin Schnure for their valuable comments. Any remaining errors or omissions are ours. 204 amy crews cutts and william a. merrill loans. It also considers some aspects of the subprime and Alt-A segments of the mortgage market.1 The primary issue is one of incentives: if the borrower values the home and if the benefits of continued ownership exceed the costs, then her interests align with those of the lender. The servicer is an agent of the investor, and to align his incentives with those of the investor, he is compensated for delivering favorable results for the investor, namely maximizing the timely repayment of the debt as agreed to in the mortgage contract. But when the borrower is in financial distress, her motivation or capacity to carry the debt typically has been diminished, thus raising the risk she will default on the mortgage, an outcome that both the homeowner and lender would like to avoid. Time is of the essence at this point because costs for all parties increase over time. The steady rise in costs drives two of our principal findings. First, the earlier the discussions between the borrower and the servicer on workout plans, the greater the chances that the borrower will be able to retain ownership, because the plan can be put into place before costs rise prohibitively to the point of unaffordability to the borrower. Second, once the loan is referred to foreclosure, starting the legal process by which the lender makes a claim on the mortgage collateral, there appears to be an optimal time frame for the state-defined legal foreclosure process. If the timeline is too short, there may be insufficient time for a borrower to recover and save the home from foreclosure. If the timeline is too long, the borrower ’s incentives are compromised by costs that continue to rise, ultimately reducing the chances that a borrower will successfully avoid foreclosure and thereby increasing costs to financial institutions. Many borrowers never speak with servicers, despite the persistent efforts of servicers to reach them by phone, by letter, or by e-mail, and the longer they wait to do so, the less likely they are to recover from their problems and keep their homes. Short-term repayment plans are effective when the delinquency is minor and the repayment of arrearages occurs over a few months, but loan modifications, even though imposing nontrivial costs on lenders, are more successful when the delinquency problem is more severe. The foreclosure process varies widely across states. Based on data from Freddie Mac in 2007, the foreclosure process lasts an average of 355 days between the due 1. The subprime segment of the market is often defined as mortgage loans made to borrowers with blemished credit, which is sometimes interpreted to mean those with FICO® credit bureau scores below 620, loans originated by a lender who specializes in subprime loans, loans with a high coupon interest rate (the current Home Mortgage Disclosure Act reporting requirement is one such example of the interest rate definition), or by loan product, such as a 2/28 ARM or 3/27 ARM loan. The Alt-A segment is usually defined by loans that have prime or near prime credit (credit scores above...

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