Taking borrowers at their word for how much they earn was a major cause of the mortgage meltdown. That practice may also be why an Obama administration program has struggled to convert temporary loan modifications into permanent ones.
The government said Thursday that it would overhaul the program by requiring homeowners to document their incomes before trial modifications are granted. Borrowers previously could have their interest rates lowered and the terms of their loans extended on a trial basis without providing pay stubs or other financial documents.
Banks and other mortgage service providers were supposed to collect those documents during a three-month trial period, with the modification becoming permanent if the borrower made three reduced monthly payments and submitted the required paperwork. But the program yielded few permanent modifications.
Last year, servicers extended nearly 1.2 million offers of trial modifications -- but just 66,465 troubled home loans were modified permanently.
Loan servicers said large numbers of borrowers failed to turn in the proper documents, and homeowners complained that the banks were unreasonable and lost paperwork.
The new procedure, to be adopted by servicers by June 1, would require three documents upfront: a formal application including a description of the hardship created by the mortgage; proof of income, which would mean at least two pay stubs or the most recent profit and loss statement for self-employed borrowers; and a form authorizing the Internal Revenue Service to release tax data to the servicer.
Under the plan, servicers will be required to respond within 10 days to an initial request for a modification. Once documents are provided, the servicer will have one month to tell borrowers whether they qualify for a trial modification.
If a borrower makes three payments at the modified rate, the modification will automatically be made permanent.
In an attempt to address a large backlog of incomplete modifications, the Treasury Department said it would allow servicers some discretion in making loans permanent if only minor paperwork was missing.
Phyllis Caldwell, chief of the department's Homeownership Preservation Office, said in a statement that the shift in policy "represents our commitment to more efficiently move qualified homeowners into permanent modifications."
Some lending groups and banks praised the changes, which they said would reduce the high volume of attempted modifications that end in disappointment for borrowers.
The changes should help borrowers better understand the process and their chance of getting a loan modified, said Kevin Waetke, a spokesman for Wells Fargo & Co., the second-largest loan servicer. Wells Fargo will adopt the new procedures March 1, he said.
John Taylor, president of the National Community Reinvestment Coalition, called the changes mere "tweaks" and said lenders should cut loan balances to avoid losing even more money on foreclosures. The government, Taylor said, should use its control of Fannie Mae and Freddie Mac to start writing down the principal on mortgages owned or insured by them "and demand that the private sector do the same."
The program, launched last spring, was designed to provide billions of dollars in subsidies to encourage lenders to forestall foreclosures by reducing mortgage payments to 31% of the borrowers' household income. The goal was to offer modifications to 3 million to 4 million Americans.
To obtain the subsidies, servicers must take a series of steps to reach an affordable payment: reduce the interest rate, extend the loan's term to 40 years and suspend payments on part of the amount owed. A permanent reduction of the loan balance is optional.
But the servicers also must calculate whether the lender or current owner of the loan will come out ahead by doing the modification or by foreclosing. If the loan owner comes out ahead with a modification, the servicer is required to make it. By documenting the borrowers' financial situation before offering a trial modification, servicers can make this calculation upfront and inform borrowers whether they qualify.
"Increasing the number of borrowers receiving permanent modifications . . . is critical to our efforts to preserve affordable and sustainable homeownership," said William Apgar, a Harvard University housing expert on leave to help the Department of Housing and Urban Development deal with the foreclosure crisis.