Loan Modification – Someone Forgot To Ask The Investors

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.