Despite some promising proposals, these factors – the presence of piggyback loans, the desire of lenders to continue to get paid unless the borrower does not have the capacity to make payments, and the legal restrictions and tax-liability concerns surrounding securitization agreements – make any across-the-board modification of loan terms challenging. 

As long as loan modifications are taking place on a loan-by-loan basis (a time-consuming and labor-intensive process), to significantly increase the number of loan modifications and avoid significant numbers of foreclosures, many servicers will need to quickly expand the pool of staff capable of making these evaluations. 

We have been pushing [mortgage servicers] to help more struggling homeowners avert foreclosure. It is our feeling, I will state very bluntly, that not enough is being done.

[The Fed is] pushing the industry to consider principal writedowns on these loans, and we have met with a lot of resistance.

As reported by Bloomberg News

 To be effective, such programs must be tightly targeted to borrowers at the highest risk of foreclosure, as measured, for example, by debt-to-income ratio or by the extent to which the mortgage is "underwater."  Finding the right balance--particularly the need to avoid programs that give borrowers who can make their payments an incentive to default--is difficult.  But realistic public- and private-sector policies must take into account the fact that traditional foreclosure avoidance strategies may not always work well in the current environment.

In cases where refinancing is not possible, the next-best solution may often be some type of loss-mitigation arrangement between the lender and the distressed borrower.  Indeed, the Federal Reserve and other regulators have issued guidance urging lenders and servicers to pursue such arrangements as an alternative to foreclosure when feasible and prudent.  For the lender or servicer, working out a loan makes economic sense if the net present value (NPV) of the payments under a loss-mitigation strategy exceeds the NPV of payments that would be received in foreclosure... The magnitude of, and uncertainty about, expected losses in a foreclosure suggest considerable scope for negotiating a mutually beneficial outcome if the borrower wants to stay in the home. 

Unfortunately, even though workouts may often be the best economic alternative, mortgage securitization and the constraints faced by servicers may make such workouts less likely.  For example, trusts vary in the type and scope of modifications that are explicitly permitted, and these differences raise operational compliance costs and litigation risks.  Thus, servicers may not pursue workout options that are in the collective interests of investors and borrowers.  Some progress has been made (for example, through clarification of accounting rules) in reducing the disincentive for servicers to undertake economically sensible workouts.  However, the barriers to, and disincentives for, workouts by servicers remain serious problems that need to be part of current discussions about how to reduce preventable foreclosures.

...

Lenders tell us that they are reluctant to write down principal.  They say that if they were to write down the principal and house prices were to fall further, they could feel pressured to write down principal again.  Moreover, were house prices instead to rise subsequently, the lender would not share in the gains.  In an environment of falling house prices, however, whether a reduction in the interest rate is preferable to a principal writedown is not immediately clear.  Both types of modification involve a concession of payments, are susceptible to additional pressures to write down again, and result in the same payments to the lender if the mortgage pays to maturity.  The fact that most mortgages terminate before maturity either by prepayment or default may favor an interest rate reduction.  However, as I have noted, when the mortgage is "under water," a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure.  

In trying to help homeowners, we must also be careful to recognize the existing legal rights of investors, avoid actions that may have the unintended consequence of disrupting the orderly functioning of the market, or unnecessarily reducing future access to credit. Provisions intended to immunize servicers from liability should be crafted to avoid creating moral hazard of parties disregarding their contractual obligations, which would ultimately have negative impacts for markets and consumers.

Home losses through foreclosure can be reduced if financial institutions work with borrowers who are having difficulty meeting their mortgage payment obligations.  In recent months, the Federal Reserve and other banking agencies have issued statements calling on mortgage lenders and mortgage servicers to pursue prudent loan workouts...  Comprehensive data on the success of these efforts to avert foreclosures are not available, but my sense is that there is scope for servicers to further increase their loss-mitigation efforts.  The development of standardized approaches to workouts and the sharing of best practices can help increase the scale of the effort, even if, ultimately, workouts must be undertaken loan by loan.  Although workouts are to be encouraged, regulators must be alert to ensure that they are done in ways that protect consumers' interests and do not disguise lenders' losses or impair safety and soundness.

Lenders and servicers generally would want to work with borrowers to avoid foreclosure, which, according to industry estimates, can lead to a loss of as much as 40 percent to 50 percent of the unpaid mortgage balance. Loss mitigation techniques that preserve homeownership are typically less costly than foreclosure, particularly when applied before default. Borrowers who have been current in their payments but could default after reset may be able to work with their lender or servicer to adjust their payments or otherwise change their loans to make them more manageable. Comprehensive data about how many loan workouts and modifications have actually occurred are not available, but some reports suggest that the numbers may be limited thus far.

Given the substantial number of resets from now through the end of 2008, however, I believe it would behoove the industry to join together and explore collaborative, creative efforts to develop prudent loan modification programs and other assistance to help large groups of borrowers systematically.

Second, I believe that modernization of programs administered by the Federal Housing Administration, which has considerable experience helping low- and moderate-income households obtain home financing, could also help avoid foreclosures. FHA modernization could give the agency the flexibility to work with private-sector lenders to expedite the refinancing of creditworthy subprime borrowers and to design products that improve affordability through such features as variable maturities or shared appreciation.

Third, we must pursue initiatives to prevent these problems from recurring, and the Federal Reserve is making strides in this direction. ... For example, as I mentioned earlier, failure to escrow for taxes and insurance can lead to a situation akin to payment shock for borrowers. It is a common practice for these payments to be escrowed in the prime markets, and I see no reason that escrows should not be standard practice in the subprime markets too.

Nevertheless, many homeowners who took out mortgages in recent years are in financial distress.  To help those borrowers, the Federal Reserve, together with the other federal supervisory agencies, has issued two statements--in April, to mortgage lenders; and earlier this month, to mortgage servicers--to encourage the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures... Often, loan workouts are in the interest of all parties...  In addition, a member of the Federal Reserve Board serves as a director of NeighborWorks America, which encourages borrowers facing payment difficulties to seek help by contacting their lenders, services, or trusted counselors...

Additionally, the Federal Reserve is working closely with community and industry groups around the country to reduce homeowners' risks of foreclosure.  The community affairs offices in each of the Reserve Banks provide significant leadership and technical assistance...