Loan Modifications Don't Work: Here's a Better Idea

When more than half of lenders’ “home retention actions”—that is, loan modifications—re-default within six months, it’s worth wondering why mortgage foreclosure mitigation doesn’t work, and whether the foreclosure crisis is worse for the loan mod efforts. It’s worth asking, too, whether the new Congress should direct billions more taxpayer and lenders’ dollars into this failed scheme.

Here’s a better idea, in my view: Rather than shovel billions toward mortgage mitigation, Congress (if it must spend) should use the funds to improve the economics of homeownership, perhaps through an increase in the deductibility of home mortgage interest, to 110% or 120% of the current allowance. This has advantages that other mitigation proposals lack, namely fairness, transparency, administrative ease, and reduced moral hazard. And when enhanced interest deductibility is no longer needed, it could be easily phased out.

As it stands now, it’s clear that current foreclosure prevention efforts aren’t working. Mortgages in foreclosure stood at 1.78% of total mortgages in the third quarter of 2008, but this rate is actually understated and continues to rise. Private lenders (such as JPMorgan Chase (JPM) and Bank of America (BAC)) have negotiated more than one million “home retention” actions–loan modifications and payment plans. But a recent study found that more than 54% of borrowers re-defaulted within six months. Many lenders foreclose on the same loan multiple times, which suggests that efforts mostly postpone, but don’t prevent, foreclosure.

Why are loan mod initiatives so widely ineffective? Apparently, many delinquent home owners game the system, by agreeing to lenders’ payment plans and loan modifications in order to delay foreclosure. They then stop payments altogether during the many-months-long foreclosure process. Several states have played the enabler by instituting mandatory foreclosure moratoriums of as much as 19 weeks. Proposals to permit mortgage “cram-downs” in bankruptcy, and the renewed emphasis on principal forgiveness, are two more examples of misguided legislative non-solutions to the problem of personal insolvency.

More importantly, the loan-mod mania might cause lasting damage to the country’s real estate and mortgage market. All these proposals share one characteristic, after all: they entail a transfer of economic wealth from the mortgage owner to the delinquent homeowner, through delay of cash payments, diminished real estate value on sale, interest rate reduction, or principal reduction. Is it any surprise, then, that the value of homes and mortgage securities continues to fall, and mortgage securitization markets remain frozen? All homeowners are hurt, not just those headed to auction.

It’s ironic, but surely the case, that lenders’ foreclosure mitigation efforts hurt MBS investment portfolio values worldwide.

And the moral hazard? In addition to the gaming behavior already evident, bailouts encourage responsible homeowners to act less responsibly, by modifying their behaviors in order to qualify for whatever break is crafted next. These will surely lengthen our financial crisis and make the downturn more profound in its consequences.

Congress should know that we understand the problem. Now it owes us realistic solutions.

Comments

[Steven Hansen:]

Gary, many would argue that the ownership deduction of interest on your taxes was one of the many distortions which caused the housing bubble in the first place.

this is a bubble. it needs to deflate quickly and not linger. this slow deflation keeps shoes falling so we cannot begin the cleanup.

Jan 21 04:00 AM

[a fat panda:]

Hand, Sound thinking. I would love to know what in your note generated thumbs down. I would add that this approach isn't just more of the distortion but re-enforces the core problem: We are living beyond our means. Tax subsidizes to encourage living beyond our means is not sound public policy.


On Jan 21 04:00 AM The hand wrote:

> Gary, many would argue that the ownership deduction of interest on
> your taxes was one of the many distortions which caused the housing
> bubble in the first place.
>
> this is a bubble. it needs to deflate quickly and not linger. this
> slow deflation keeps shoes falling so we cannot begin the cleanup.

Jan 21 09:03 AM

[Gravedigger:]

The argument that the various schemes represent a transfer of economic wealth from lender to homeowner is fundamentally wrong. The proposition which you draw from that misapprehension is likewise incorrect. Both parties have lost the "wealth" already; it's gone. If the lender forecloses in the present climate, it can only recover by selling the property again. It will not recover more than the market value. Unfortunately, the market value has been trashed by the rush to foreclosure by all of the lenders, and is not likely to recover in the near term. Failed restructurings are evidence that neither the borrower nor the lender recognize, or are willing to recognize, the full extent of the reduction in market value. The phenomenon has nothing to do with moral hazard, but rather with the lingering fantasies of both parties. Since neither is likely to give up their fantasies in a reasonable timeframe, what is the harm of getting some cash flow from 54% and full cash flow from 46% until the lenders wake up and begin lending to qualified buyers? And in the meantime, families have a roof over their heads, which is sound public policy.

Jan 21 12:07 PM

[MTB:]

Everybody has an opinion, suggesting "better ways" to stop this rock from rolling down the hill, but you can't. Let's cut the chase - if you meet the criteria to be eligible for a loan mod., sure you'll milk it while you are looking for another place to live, saving your cash, paying nothing but utilities and maybe your car. Let's face it, if your going to lose your house and file bankruptcy, find a place to live before you do. The underlying fact to all this talk is very simple - the house is worth much less than you owe, you don't want it anymore! The loans were made in "greed" and now it is time to pay for the reckless money driven decisions.

Jan 22 10:03 AM

[pat daigh:]

The fact is, people that did loan modifications with their lender 6 months ago didn't get any real assistance. They got what the bank gave them, and without real representation in the loan modification process, by a real and credible loan modification company, they are only getting a band aid, instead of a real solution. Gary, on the side of the bank, wants to blame the consumer for the economic woes that are facing the nation. 1 in 10 homes is currently in some form of late status in the US and this isn't because all these homeowners are flakes or trying to pull a fast one on their lender.

A gentleman I just got off the phone with is a perfect example. The guy got hurt and was out of work for awhile. His wife had her hours cut. Having double digit interest rates, they are now 2 months behind on their mortgage. Their lenders solution was to increase their monthly payment with a balloon after 6 months, a payment they are wondering they will get the money from. A good modification, would have given them a 30 year fixed rate at a current low market rate, and a payment they can afford for the long term. Poor bank won't get their double digit return skinning these folks, but the lender also won't be saddled with a more costly foreclosure and a loan that for them is now a non-performing asset which increases their reserves for such loans. Long term thinkers would give the borrower a payment they can afford, making that loan a performing asset, allowing the lender to free up capital to lend to others. Now, we don't need a bail out.

Back to the poor folks in their bad loan, since they executed the 'one size fits all' approach their lender gave them, they are now precluded from doing another modification for 12 months in most cases with most lenders. They will lose their home of 20 years, where they raised their kids, and all the memories to go with it.

Therefore, if you are going to attempt a loan modification, you had best make sure you have legal representation coming from a reputable loan modification company that will get you real long term results and that has a track record of performance with your lender. Your bank, like Gary, will try to blame you, and they have their own attornies. You need your own attorney who knows the lender, has modified loans in the past with that lender and knows the lenders 'sweet spot' for getting you the best deal. Its you against the bank and they are not your friend.

Imagine going to buy a car, you walk on the lot, pick out the car you like and the salesman goes to talk to his 'sales manager'. After 15 minutes talking to his girlfriend, he comes out to give you their best price. Now imagine hiring someone who knows that car, and has purchased that car several times from that dealership. Who do you think will get you the best deal?

Jan 22 08:49 PM