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Wednesday, February 25, 2009

Loan Modifications for Dummies

Ahead of what is sure to be an ugly existing homes release, lets see how loan modifications can work (albeit in a highly simplified world without securitized loans and continually falling home prices). For both the homeowner, who gets to keep the house / retain a portion of equity, and the lender, that does take a haircut, but gets paid back more than after a distressed sale of the collateral in a foreclosure, it can be a win-win.

How? Lets take a look:

In December, 2008 the median home price in the western region of the U.S. went for $213k, down more than 30% from a year earlier. This wiped out all the equity of the homeowner if they put down 20% one year prior. At this point it appears the homeowner eats most of the loss, but the problem is the homeowner is likely to "walk away", leaving the outcome to the lender's foreclosure process. Assuming a 30% haircut selling in this distressed market, the lender ends up eating a huge portion of their original loan.

While that story is now well known, the lender does have the opportunity to modify that loan amount. Assuming a $55,000 reduction in the loan to put the homeowner $10,000 back in black (of which a portion is from losses the lender expects simply from the market downturn), the homeowner has the incentive to stay and the lender isn't force to sell the asset in a distressed market. This in turn creates more value for the existing owner of the loan.

Again, if only life were so simple...