From my industry contacts and investigation of the loan modification “business” there are several conclusions easily reached:

- The Internet is extremely crowded with unknowledgeable, coarse idiots who are all attempting to haphazardly create businesses doing loan modifications. Very few of them have thought through whether or not they can be profitable, or the long term destination of the new industry.Many of the new loan mod businesses are being started by unemployed members of the mortgage brokerage industry who helped to create the very problem that they are now offering to cure. In fact, the very same people who were “helped” by the mortgage industry by getting them approved for subprime and Alt A mortgages are now on the top of the calling list as potential “loan mod” customers.

- The press is highly critical of anyone who tries to assist homeowners with loan modifications. Beyond news driven stories, the only loan mod stories are about bad providers who charge huge upfront fees and deliver little or no results, or others who are simply defrauding customers outright.

- The press and the government, for lack of a real solution, see the idea of loan modifications as THE solution to the housing crisis. If payments are lowered for 2 million of the country’s biggest financial losers, the economy will snap back immediately, job losses will cease and all will be well.  The consensus seems to be that the government should pay for this, and make rules about which people are “distressed” enough to receive a lower rate and mortgage payment through a loan mod. The cost of all of this, as you may guess, will be borne by those who handled their finances responsibly and did not borrow themselves into oblivion speculating on the certainty of eternal home appreciation.

Here is where I think things are going:

- In response to concerns about fraudulent or unknowledgeable companies assisting with loan modifications, most states will implement licensing requirements, as is already happening. Among other things, to maintain the license, you will be subject to strict guidelines on how much you can charge for loan modifications. The fees will be low enough to make any business which exclusively performs loan modifications unprofitable; the theory being that people behind on their mortgages should not have to pay since they are in financial difficulty.  Several states have recently created licensing requirements. Colorado was the latest: http://www.rockymountainnews.com/news/2008/nov/20/loan-modifications-require-mortgage-broker/ .

- As more of our nationalized banking system is pressured/required to do loan modifications, certain universal standards and calculations will develop. These will eventually evolve into a simple calculation that will require only a few inputs to determine exactly how a loan will be modified. This may even reach a point where banks routinely modify loans without even taking an application. This technology provider for the mortgage industry just released an early version of such software: http://www.marketwatch.com/news/story/Lender-Processing-Services-Announces-New/story.aspx?guid={58FCD216-F636-4EF9-8B93-5C1C1A41AD2F}

- The government will eventually fully endorse the idea of loan modifications for troubled homeowners and subsidize the losses. Of all the problems the country faces, for some reason the politicians will decide that keeping 2 million “homeowners” (who should be renters) out of foreclosure is the most pressing issue, instead of letting the free markets, via time and price solve the problem. With the government involved, the criteria will become even more formalized and systematic. Loan servicers or banks will be encouraged or required to deal with borrowers directly. The entire process will become formulaic and there will be little need for an outside party to assist with the loan modification.

- As modified loans default again and further borrowers fall into distress, whatever small scale plan the government implemented will be expanded dramatically. The government will increase pressure and incentives for banks and loan servicers to perform loan modifications en mass. Getting a loan modification will become as easy as it used to be to get a loan. Of course, one may wonder when it last occurred, that a government solution to a problem actually worked. Nonetheless, as home prices continue their inexorably decline for years and given the inability to find a better solution, this program will continue and expand, attempting to artificially arrest the decline in home prices that will occur anyways. Someone should clue in the powers to be that unless we want to totally socialize our economy, the free market, if left to do its work, would quickly solve the housing crisis by bringing prices to the point where they are worth investing in again and at a ratio of family income to cost that is sustainable for qualified borrowers.

Conclusion

Loan modification as a stand alone business is transitory since circumstances will change to make the current business models obsolete. At the same time, the fees that will be legally allowed will be too small to allow most businesses to be profitable. To turn this into a business, one would need to align his strategy to be way ahead of the curve and I have only seen one business model for loan modifications that would work if applied by an industrious and ethical entrepreneur.

In the meantime, potential customers who are solicited to have their loans “modified” would be well advised to do a complete background check on the firm that they may chose to deal with. In addition, under no circumstances should anyone pay a nonrefundable fee upfront (other than a modest processing fee). Guidelines vary with each loan depending on the investor, but if you are dealing with a knowledgeable firm, they should be able to determine from an initial prequalification if someone qualifies for a loan modification and accordingly, should only charge a fee if the loan is successfully modified.

As to the financial cost and moral hazards of the loan modification scheme, one should consider the words of Representative Ron Paul, when speaking out against the original $700 billion bank/homeowner bailout bill:

“It is neither morally right nor fiscally wise to socialize private losses in this way. The solution is for government to stop micromanaging the economy and let the market adjust, as painful as that will be for some. We should not force taxpayers, including renters and more frugal homeowners, to switch places with the speculators and take on those same risks that bankrupted them. It is a terrible idea to spread the financial crisis any wider or deeper than it already is, and to prolong the agony years into the future. Socializing the losses now will only create more unintended consequences that will give new excuses for further government interventions in the future. This is how government grows – by claiming to correct the mistakes it earlier created, all the while constantly shaking down the taxpayer. The market needs a chance to correct itself, and Congress needs to avoid making the situation worse by pretending to ride to the rescue.”

News Release: Sometime in 2010.

The United States Treasury Secretary is expected to release details today of the Government’s plan to suspend for one year all payments due on mortgages secured by single family residences.  The Government announced that it was taking this action due to unprecedented conditions in the economy and record numbers of mortgage delinquencies.   With close to half of all mortgages in arrears, a jobless rate approaching 20% and retail sales collapsing by double digits for the third consecutive year, the latest government move to boost the economy was applauded by analysts as the best direct method of putting funds in the pocket of cash starved consumers.

Government officials noted that since most of the mortgages affected had already been purchased or guaranteed by the US Government, there would be no direct cost to the taxpayer.  Analysts noted that this latest move was necessary after a long series of loan modifications for many borrowers had failed due to the continued decline in housing prices and incomes.  Brushing aside suggestions that this program was unfair to those who had no mortgage debt, Treasury officials stated that the program was initiated to help those most in need and that those without mortgages might be eligible for funds under the latest rebate stimulus plan.

In response to questions as to whether or not the Mortgage Holiday Plan might be extended beyond one year, Treasury officials stated that the Government would do everything in its power to assure that affordable housing was available to every citizen and that every measure would be taken to prevent homeowners from losing their homes due to unaffordable payments.

The Treasury Secretary noted that while many sovereign nations had become insolvent due to the ongoing financial crisis, the United States remains “fiscally strong”.

So there you go; congratulations to the Federal Reserve and our fiscally imprudent leaders who have brought this nation to the brink of economic collapse.

Purchasers of mortgage debt, formerly known as investors but now known as bag holders were distressed that Bank of America (BAC) did not consult with them prior to deciding to modify customer mortgages, as reported by the Wall Street Journal.   The problem was not with the mortgages actually owned by BAC, but rather the mortgages owned by others and merely serviced by BAC.  Apparently so enamored with the idea of saving the banking industry by reducing the rate and loan balances of the lucky mortgagees, BAC decided to apply their therapy to mortgages that they merely service but do not own.

The problem with attempting to modify mortgage loans en masse is that many mortgages originated over the past 5 years were sold to investors as mortgaged backed securities.  BAC maintains that they can modify these investor owned mortgages based on “delegated authority” per the loan servicing contract they have with the investors.   Obviously some of the investors in the serviced mortgages don’t see it that way and are looking to BAC to make them whole on any write downs given to the borrowers at their expense.   These are the types of issues confronting the industry in their attempts to modify mortgages.

Mortgage modifications are seen as a win/win situation by the FDIC, many banks and some of the mortgaged backed securities investors since it appears to offer the ideal solution - homeowners get to keep their homes, foreclosures decrease and the ultimate loss on the loan modification theoretically is less than   foreclosing on the property.  This may all be work out to every one’s advantage unless property values continue their decline which I consider to be a likely scenario.   Home prices won’t stop dropping regardless of government efforts until the economy stabilizes and until the ratio of family income to cost of ownership reaches an affordable level.

The issue with loan modifications that I and others see is one of moral hazard; this program is institutionalizing the repudiation of debt on a national scale and the cost and negative consequences of this rationale are open ended.  In an excellent article by Peter Schiff, he describes loan modifications as “the mother of all moral hazards” as follows:

“No doubt prodded by the administration, Fannie Mae and Freddie Mac announced a new attempt to stop the fall in home prices and foreclosures through a loan modification program that would cap mortgage payments so that a homeowner’s total housing expenses would not exceed 38% of household income for home owners who are 90 days delinquent.

In a classic case of unintended consequences, the plan will encourage a massive new round of delinquencies and household income reduction as homeowners will jump through hoops to qualify for the program and maximize their benefit. Those who could conceivably economize to meet their existing obligations will now have a strong reason to forgo such sacrifices. Those who are not 90 days past due will intentionally become so. In many cases, dual income families may decide to eliminate one job altogether as reduced mortgage payments combined with lower child care and other work related expenses will likely exceed the after-tax value of the lost paycheck.

Unfortunately, the last thing our economy needs is falling household incomes and even more bad debt. But that is precisely what this plan will give us.”

Transferring all the losses of homeowners, automakers, banks, insurance companies, credit card companies, mortgage companies etc etc onto the balance sheet of the US Government does not correct the incredible excess of leverage that has been ongoing in this country since the early 1980’s; it merely transfers the losses to the US taxpayers and shortens the day that the US Government itself will need to be bailed out.

Despite the horrendous 72% sell off in American Express this year, I would still not be a buyer at the recent price of $19 for the following reasons.

From my personal experience in the mortgage business, I have seen many people turn to their credit cards once the home equity cash out loans were no longer available to them.  The credit cards were used to maintain a now unsustainable life style or to bridge the gap between income and living expenses.  Now that credit card lines are being reduced or simply maxed out, the last option for many people is now closed.  Since AXP gets around half of their revenue from the fee charged to merchants when a credit card is used, this income is obviously going to see a reduction.

Moody’s recently cut AXP’s investment grade by one notch to A2 (still very respectable) but the trend is clear.  Moody’s is expecting the recent earnings decline at AXP to continue, especially in view of the broad economic weakness and overleveraged consumer.

The fact that AXP decided to request $3.5 billion in capital from the Treasury’s TARP fund also raises many red flags - if AXP wasn’t expecting further problems in its basic business they would not be requesting theses funds.  In any event, AXP needs to refinance approximately $24 billion of debt over the next year; if the credit card securitization window remains closed, AXP may be back in line very soon for another TARP injection.

AXP expanded its business during the peak of the credit boom, expanding their credit card loans by some $26 billion over the past 4 years - an increase of 68%.  Timing is everything and they definitely got this one wrong, possibly by assuming that an overextended credit card customer would simply pay off his unmanageable credit card debt with his next cash out mortgage refinance.  Unfortunately for AXP, the days of constantly borrowing more money to pay off past borrowings has come to a halt.

Also, extremely unfortunate for AXP is the consumer attitude that debt that cannot be easily paid off should be easily forgiven, either by the company that lent the money or the bankruptcy courts.  If AXP needs proof of this, they can check out the Bank of America, Citibank, JP Morgan etc loan modification programs for mortgages.  At a time when collarteralized debt is being forgiven, unsecured credit card debt will be easily walked away from as well, as evidenced by the 100,000 plus (and increasing) personal bankruptcy filings each month.  Overleveraged consumers forced to borrow for years to bridge the gap between incomes and expenses will no doubt have no trouble being approved for a Chapter 7 debt liquidation instead of the Chapter 13 payment workout resulting in zero recoveries for AXP on outstanding credit card debt.

If you apply conventional, historical valuation metrics to American Express, the stock looks ridiculously cheap.   Unfortunately, I don’t thinkthe present economic disaster is going to end anytime soon and if that is the case, AXP will be facing a bleak future not only in its future earnings but also in its ability to refinance their 6/1 leveraged balance sheet.

As discussed in a previous post, Bank of America agreed with the state attorneys general to offer  concessions to 390,000 sub prime and pay option arm borrowers by reducing both the principal owed and/or the interest rate to a level that allows these borrowers to have a an “affordable and sustainable” monthly mortgage payment.   An affordable and sustainable payment was determined to be a mortgage payment (including taxes and insurance) that would not exceed 34% of gross monthly income.   With this agreement apparently setting a standard for future concessions to homeowners, consider some recent mortgage transactions/applications that I have seen.

• Woman wants to refinance her Connecticut home which she bought in early 2006.  The home today would probably sell for no more than $260,000.  Home was purchased for $305,000 with 95% financing; the current interest rate is at 11.625% and she owes $285,000.  The negative equity is only $25,000.  Borrower has a gross monthly income of $3780 per month and her current monthly payment of principal, interest, taxes and insurance is $3682 giving her a debt ratio of 97%.   She is currently in arrears on the mortgage and obviously not capable of making the payment.   In order for her payment to become “affordable and sustainable”  with a 34% debt to income ratio, the lender would have to reduce her loan balance to $158,000 with an interest rate of 1%.

If the home owner gets this deal, not only would her payment become affordable, she could also sell the house and reap a gain of $102,000.  The applicant’s income is about the same today as it was when she purchased the home, so there was no drastic decline in income.  Obviously, this woman should have never been approved for a mortgage in the first place; both the bank and borrower knew this.

• A self employed carpenter applied for a mortgage to purchase a home for $185,000.  Applicant has no credit score since he pays for everything “in cash”.  The yearly income reported on his tax return for the past two years averaged $5500.  When I told the applicant that he did not qualify he became indignant and arrogantly proclaimed that his bank told him they would approve him; I wished him good luck.  This guy hasn’t been reading the papers lately but the days of borrowing based on what you say your income is are over.   The applicant understood his situation; his income averages $458 gross per month according to his tax return and the monthly mortgage payment with taxes and insurance would have been at least $1650 per month which he insisted he could afford.  I would say that the IRS should conduct more audits of self employed individuals.

• Borrower with very good credit and working two jobs has a sub prime mortgage and applies for a lower rate under the FHA mortgage program.   Borrower gets approved with with a debt to income ratio of 56%.  At this point, instead of bringing his lunch to work everyday, he might be better off to stop paying on his mortgage and  ask his bank for a loan modification once he is delinquent.  The interest rate would need to be reduced  from 6.25% to 1% which would put him at the recommended 34% DTI.  Although most loan modifications are currently being offered only to sub prime and pay option arm customers, I am certain that in the name of equitable treatment, the offer will expand to include the multitudes of other borrowers with a debt ratio over 34% .  Why discriminate against better credit borrowers?

• Borrower with fair credit purchases a home with 100% FHA financing with the help of a down payment assistance program.   Borrowers debt ratio at time of approval was 48%, which is extremely high and not affordable or sustainable for very long.  Why is the FHA approving loans at this ridiculous debt ratio when the state attorneys general are forcing Countrywide to modify loans to a debt ratio of 34%?  I suggest that a state attorney general be named Head Underwriter for the FHA.

I could go on and on, but one thing is for certain; there are millions of home owners currently in a stressed income situation with negative home equity who would like to refinance but can’t due to low credit scores/lack of home equity or both.   As word spreads of the great deal that Countrywide borrowers got from the recent Bank Of America settlement, there will be many indignant and angry home owners demanding the same treatment.   Can the banking system, already insolvent, handle huge new write downs?