Inside Financial Services

Memo To The White House: Wide-Scale Loan Modifications Won’t Solve The Mortgage Problem

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What in blazes?:

The Obama administration is trying to push through a settlement over mortgage-servicing breakdowns that could force America’s largest banks to pay for reductions in loan principal worth billions of dollars.

Terms of the administration’s proposal include a commitment from mortgage servicers to reduce the loan balances of troubled borrowers who owe more than their homes are worth, people familiar with the matter said. The cost of those writedowns won’t be borne by investors who purchased mortgage-backed securities, these people said.

If a unified settlement can be reached, some state attorneys general and federal agencies are pushing for banks to pay more than $20 billion in civil fines or to fund a comparable amount of loan modifications for distressed borrowers, these people said. [Emph. added.]

What oh what is this strange obsession the people in the Obama administration have with loan modifications, and is there a pill someone can give them to cure it? This notion of a “unified settlement” to benefit delinquent mortgage borrowers is a terrible idea. It won’t help borrowers. It won’t help lenders. It won’t help virtually anyone. Here’s why:

• A global loan mod deal would invite moral hazard, on steroids. Only “troubled borrowers” will get relief? Count me in! It’s the easiest thing in the world for a borrower who’s current to render himself delinquent unilaterally, simply by closing his checkbook. His cash flow improves right away, and his default makes him eligible for the principal reductions his less-prudent neighbor is already lined up for. People will unilaterally default in droves and expect to become eligible for the deal, regardless of what anti-moral-hazard safeguards are proposed early on. (They might even be right; these people vote, remember.) Borrowers would be idiots to not default. What do you think that would do to banks’ loan quality?

• A deal would divert bank capital from other, more productive uses. Like, for instance, lending. Only last week, as she delivered the banking industry’s fourth-quarter report card, Sheila Bair said that “we need to see more lending” on the part of the banking industry. Maybe so. But if banks are going to be forced to shell out for civil penalties to pay for real or imagined transgressions, and shell out some more for principal forgiveness they’ll be strong-armed into granting, there’s going to be that much less available for writing loans that actually have a chance of being paid back. That would not, I should add, be auspicious for the outlook for economic growth.

• Loan mods don’t provide real relief for borrowers. The numbers aren’t just bad; they’re awful. One-third of borrowers who qualify for a modification don’t even make it through the three-month trial period. And as Joseph Mason points out in Friday’s Wall Street Journal, half of those who do make it through the trial re-default within six months. What exactly is the point? The vast majority of modified borrowers end up losing their homes anyway.

• This kind of government intervention will make mortgage credit scarcer and more expensive. Now that lenders know that a mortgage is no longer a simple contract between consenting adults-that, instead, the government might come swooping in to alter the deal’s terms to the material advantage of one of the parties-they will factor that knowledge into their pricing of future loans. Believe me, it won’t make ‘em cheaper.

• Loan modifications squeeze more money out of delinquent borrowers for no reason. If a severely delinquent borrower inevitably face foreclosure (and the numbers are emphatic that that’s the case), why string him along for a few extra months? For the borrower, one of the advantages of foreclosure (and, yes, there are a few) is that he gets to live in the property rent-free for several months. This housing recession is so severe that that can add up to a mini-windfall. These days, typical foreclosure doesn’t happen until 18 moths after the loan first becomes delinquent. That’s a lot of rent-free living. Plus, the sooner the foreclosure, the sooner the borrower can move on with his life (by, say, moving to a city with a better employment outlook) without having to sell the damn house first. So for most borrowers, the loan mod process takes a bad situation worse.

The government has been pursuing its loan modification strategy for so long by now that it’s become abundantly clear that massive, government-instigated loan mods are a terrible idea both in theory and in practice. Have these people learned nothing? A global modification deal would be bad for lenders and borrowers, and a threat to economic growth. The sooner this trial balloon gets popped, the better.

What do you think? Let me know!

12 Responses to “Memo To The White House: Wide-Scale Loan Modifications Won’t Solve The Mortgage Problem”

  1. G

    Tom, agree completely. Not sure what the fascination is with loan mods, other than it is the platform by which someone was elected and is quite possibly the strategy for getting re-elected. Just kick the can far enough down the road to get beyond the next election. And here’s the kicker: even the loan mods that go through – the so-called “permanent” mods – aren’t permanent. They only last 5 years. Then we get to go through the same song and dance again. What’s truly sad is that the govt has a program that can actually avoid future foreclosures and decrease the likelihood of strategic defaults – HARP. But the Home Affordable Refinancing Program gets zero attention, and the LTV requirement of 125% is way too low to help many borrowers in the sand states, particularly those that are current with payments, have the means to pay, but are stuck with a loan (such as a 5/1) that is no longer suited to their original timetable when buying the home. Those are the future defaults, strategic or otherwise, that can be avoided just by diverting focus away from the silly “extend and pretend” of HAMP to the more meaningful but largely ignored HARP.

  2. Chuck

    In lieu of a reduction in their loan balance, how about a free one-way trip to a socialist country of their choice with a few dollars to get them acclimated to their new country.

  3. jsc173

    What this administration doesn’t understand about banking in general and mortgage lending in particular makes every previous administration appear to be geniuses by comparison. On the one hand they admit that Fan/Fred was a disaster and that the future of mortgage finance is the banks, but at every turn of the road they are creating minefield after minefield for all banks, particularly community banks. The newest twist I’ve seen in a current exam is credit management rules for commercial lending are being applied to consumer mortgages, all in an effort to put more and more capital pressure on community banks. Disgusting.

  4. blankst

    “A deal would divert bank capital from other, more productive uses.”

    That’s the rub. The broad perception among the public is that banks have failed to perform on providing funds for productive uses. Banks assert but apparently cannot prove (or even pursuasively demonstate) that they are providing loans at an appropriate level to meet the legitimate economic needs of their customers or the country as a whole.

    In short, where’s the “capital…(for)…productive uses” now? Why believe that banks will do better at performing their function of efficient allocation of capital? Why believe the whining bankers?

    I believe all the arguments presented in your article but I can also see why those arguments are ignored by the public and the administration.

  5. Terry Penn

    You just can’t get good help in DC anymore.

  6. Frank

    Another populist idea out of the White House. The traditional 30 year fixed rate non-recourse( in some states) mortgage is looking more and more like a Dodo bird. Why would any bank participate in loan markets where borrowers can walk away with impunity.

  7. jerele

    Another bad mortgage modification idea. The longer the foreclosure process is delayed by various political forces the more problems the housing market faces.

  8. No Banker Left Behind

    TB: Actually, this time, I agree with you. But let’s see why the banks may not want, despite their protestations, be so eager to see this form of extend and pretend ended. I turn to Barry Ritholz of The Big Picture, whose latest entry this morning I excerpt: “Under normal circumstances, the bad mortgage process goes Delinquency (late payments) Default (90 days behind), Foreclosure (legal proceedings to enforce the note).

    Once a home goes into foreclosure, the accounting changes: It is now a loss that must be written down immediately. That hits the banks capital levels. Consider what the next 3-5 million foreclosures will do to banks’s capital cushions.

    Once a foreclosure occurs, not only does the capital write down take place, but the local property tax liability accrues to the bank; prior to foreclosure, the liability is to the nominal home owner and/or property. Once the bank takes possession, its on them.

    Hence, you can see why “Extend & Pretend” is so attractive to the large institutions sitting on massive REO inventory, enormous bad loans and CDOs, and huge future local tax obligations.

    I wonder: How many bad loans are on the books as either performing or in modification when they are nothing of the sort? What are Citi, Bank of America, Wells Fargo and even JPM carrying that are misrepresented on their balance sheets?

    Lastly, consider this: If banks had to accurately report their balance sheets, if they were required to give a full and honest accounting,many of these institutions would be declared insolvent.

    We are now in a race to see what will come first: The next regained health and stability of our incompetently run banking sector, or the next crisis.”

    Please comment.

  9. Crazy Itailan

    If you can believe it i do agree with you on this one. Most things you are wrong about.Ifyou make acommitment to buya home if you cant afford it the gov shouldnt ball you out

  10. ACEMAN

    In our neck of the woods, Attorney’s who have just stepped out of a recent seminar, are on TV and all media, claiming that according to state laws adopted in Nevada and California and other Western states, you can stay in your home without paying local property taxes or mortgages. Thus local property owners are losing value and are being hit by new and ad hoc real estate taxes. This pits neighbor against neighbor, have nots against haves in uppper middleclass neighborhoods.It has become the “OLD West” with threats and who knows what will follow…the frustration with local banking institutions, namely Bank of America is palpable and fraught with danger and lawlessness. The local and Federal governments are unprepared for the level of dis-affection among formerly middleclass folks. There is a budding revolutionary climate and gun sales have boomed as threats have escalted. The current Federal government seems to be powerless to pressure mortgage lenders and big banks to modify their foreclosure standards. Thus the people are angry and don’t wish to take it any more. Of course, a credible jobs program would help immensely. $684*$ million expensed last month to fire missiles at Libyan targets shows that this administration has its priorities wrong
    ACEMAN in CA

  11. Anonymous

    I market homes and am seeing the housing market up front and personal The law of supply and demand is like the sun rising in the east and setting in the west.
    There is no stopping it and all that tampering with it just delays the inevitable and the inevitable according to Case-Shiller is when inventories reach 5to 6 months we will have price stability. The market will solve its own problems and does not need help.

  12. Anonymous

    How about just paying down princepal at the T bill rate instead of getting screwed by the usuary rates.
    How can a person repay a loan when the pricipal keeps increasing.

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