Sheila Bair Needs to Get Over This Loan Mod Thing

Dec.24.08 | About: Financial Select (XLF)

Sheila Bair warns of a “backlash” against MBS investors who’ve challenged loan modifications in court, and announces that lenders have “an obligation to modify, not to foreclose.”

Oh, really? An obligation to whom, exactly? There’s no shortage of duties in the money management business, but this sounds like a new one. Those MBS holders who have Bair so exercised, for example, do have a duty to act in the best interests of the investors who’ve entrusted them capital. It’s basic. Suing lenders and servicers to prevent an unnecessary reduction in value of the loans those investors own strikes me as precisely what the bondholders should be doing. If the head of the FDIC knows of something that trumps bondholders’ fiduciary duty, I’d love to hear what it is.

Sheila Bair’s obsession with loan mods is nutty--but is characteristic of the political cowardice, masquerading as populism, that’s characterized her tenure. First, she caved when Wal-Mart wanted to open a bank. Then she came up with unworkable guidelines for small-dollar (read: payday) loans. Now, this guardian of the soundness of the nation’s banking system (!) insists on an industry giveaway to subprime borrowers. Outrageous.

A loan modification decision is simple: if a mod results in a higher net present value to the bondholder than foreclosure would, the loan should be modified. If not, the property should be foreclosed. Easy! To put it another way, the bank should choose the least-costly option, in order to protect its financial strength. I would think the head of the FDIC would be in favor of that. In the current housing market, yes, modifications make sense a lot more often than they did in prior cycles, as home prices (and recovery rates) fall.

But they don’t always make sense. And Bair’s blanket implication that modification is preferable for the borrower in every case is crazy. Often, remember, even modified loans go delinquent again, and then end up in default. How’s the borrower helped in that case? Worse, an overemphasis on modifications ignores what got us into this pickle in the first place: too many lenders lent too much money to too many borrowers who weren’t qualified. Those people never should have been homeowners in the first place. More than a few of them lied on their applications. Others had never been homeowners before. And they’re all supposed to be allowed to stay where they are? Why?

As Elizabeth Warren will rightly tell you, the vast majority of defaulted borrowers aren’t moral reprobates. They’re just unlucky. Most run into financial trouble as the result of a) death or divorce of a spouse, b) a severe illness, or c) loss of employment. Yet as mortgage credit quality has crumbled, I’m not aware of any rise in disease rates among the nation’s borrowers, or a spike in their divorce rates, either. Employment has held up well until only recently.

No. Mortgage credit has imploded because—and this has been in all the newspapers, so I can’t believe Sheila Bair doesn’t know it—lenders’ underwriting was incredibly sloppy. People were given mortgage loans (often, via fraud) who never should have been. Now the problem has been identified. Most of those people are going to have to move out of the houses they never could afford, and the financial industry has to take huge resulting losses and then clean up its balance sheet. It’s on to the next chapter, and the sooner the better.

Nor, as long as I’m on the topic, do I understand politicians’ new fetish with foreclosure moratoriums. (General rule: if Charlie Crist thinks it’s a good idea, it’s probably not.) What good are moratoriums supposed to do? If a borrower is hopelessly delinquent now, nothing will likely be different 30 days, 60 days, or 90 days hence that will make him current. All that will happen is that the property will continue to decline in value, and perhaps be subject to more vandalism, so that the lender’s recovery will be that much lower than it would have otherwise been. What is the point? Just go ahead and foreclose and let everyone get on with their lives.

Sheila Bair is the media’s favorite financial regulator. In fact, she is a disgrace. She didn’t do consumers any good when she took a powder on Wal-Mart’s banking application, or offered her small-dollar-loan plan. And she’s certainly not doing them any good when she pushes for uneconomic loan mods, which will only delay the inevitable. Worse, she’s not doing the banking system any good, either.