Bank of America agreed with the state attorneys general to offer astonishing concessions to 390,000 subprime and pay option arm borrowers that will cost upwards of $9 billion, as reported on by the Wall Street Journal.

Summary terms of the settlement with borrowers for loans made by Countrywide Financial include the following:

Mandatory loan modifications are required due to “unfair and deceptive” practices.

Supposedly this action will keep borrowers in their homes, support local communities and the general economy.  Some background here: loan modifications, still off the mainstream press, have over the past year grown into a sizable cottage industry, manned mostly by ex loan officers and former lenders, who for a fee, will negotiate with the borrowers bank to try and obtain a reduction in either or both the interest rate and the principal balance.

Many lenders are now and have been proactively contacting borrowers and offering them a loan modification where it was obvious that the borrower was in over his head.  The biggest impetus to loan mods was by Indy Mac after being taken over by the FDIC where 38,000 borrowers were sent letters offering to reduce their payments by either rate and/or principal reductions.

Loan mod results to date have been uneven, and each lender has been individually offering concessions where they see it to be in their best interest.  To date, most of the loan mods have been an interest rate reduction since the mortgage investors are hoping that eventually property values recover and their write downs will be limited.  In cases where only an interest rate reduction was offered, initial stats suggest that only 20% of borrowers are still current six months later  thus necessitating either a foreclosure, recovery, or another loan mod.

I recently spoke to a woman in Massachusetts who had a subprime mortgage with Chase at 12%; after months of phone calls and sending paperwork to Chase, she was given a fixed rate of 1% for 5 years, with the rate to rise in steps to 6.25% at the end of 10 years.   The lender did not, however, adjust the loan principal and she has negative equity of around $80,000.  Whether or not this loan mod works out for both parties is subject to debate.

In an excellent post by Mr Mortgage, a very compelling argument is made that negative equity is one of the prime motivators for payment default by the borrower, regardless of the rate.  Apparently the attorney generals read Mr Mortgage, since the loan mod mandate settlement requires that changes be made to the borrowers loan so the that loan payment is “affordable and sustainable”; thereby necessitating in most cases both a rate and principal reduction.

A Credit Suisse study of subprime loan mods, however,  indicated that over 20% of subprime mortgages in which a principal reduction was granted were 60 days delinquent on their mortgages within eight months of the loan mod, so the success rate is not much different were only a rate reduction was granted.  Keep in mind that all the statistics on loan mods are preliminary and based on small sample numbers over short periods of time since there have not been a great number of loan mods done to date.

Borrowers’ monthly PITI (principal, interest, insurance and property taxes) should not exceed a 34% front end debt ratio.

This means the PITI should not exceed 34% of the borrowers’ monthly gross income.  See my post on Mortgages still being approved for unqualified borrowers) and Unsound lending policy.

For borrowers who took out pay option ARMs, Bofa will reduce the loan amount so that borrowers have as much equity, if not more, than when they took out the loan.

Borrowers will not be charged for the loan mod and any prepayment penalties will be waived.

The mandate that no fee be imposed on the borrower for modifying the loan will make it very questionable from an ethics and business standpoint for the nascent loan mod industry to try and attempt to charge a Countrywide mortgagor a fee to modify their loan, since Bofa will be contacting all the Countrywide customers with no cost offers to modify their loans.

In those cases where the loan is serviced by Countrywide but owned by an investor, Bofa will work with the loan servicer to get the necessary approval for a loan mod.

BofA will send offers of a loan mod to qualified borrowers by December 1 and stay any foreclosure action until a borrower’s eligibility has been determined.

Bofa will provide $150 million to refund some closing cost on the original loan if the borrower is in foreclosure and also provide $70 million of “key money”, cash payouts to help with moving costs.

It is only logical to conclude that since one of the largest banks in the country has agreed to this type of settlement that virtually every other lender and loan servicer will also be required to participate, either by invitation or legislative decree.  Indeed, banking regulators are now calling on every subprime loan servicer “in the strongest possible terms” to adopt a similar loan mod program as possible.

In the rush to “do something”  to address the foreclosure problem, it appears that there is a collective rush to judgment that loan mods are the best manner in which to address the problem.   Superficially, it appears to be a compelling solution to the problem; make the payments low enough so that the homeowners can easily make their mortgage payments.  Every easy solution, however, seems to create unanticipated adverse consequences.

Specifically, the following issues may cause adverse consequences that outweigh the presumed advantages:

1. Moral hazard may be a significant factor.  I talk to many people who would like to refinance but cannot due to insufficient or negative equity in their homes.  Most of these people have good credit and sufficient income to pay their mortgage but many of them (especially with negative equity) bring up the question of whether or not they should stop paying their mortgage and mail the keys back to the bank and to what extent this would impact their credit.

As publicity about the loan mods programs grow, the flood gates could open here especially since there are around 12 million households that now owe more than their house is worth according to Moody’s Economy.com.  Modifying a loan may sound like an easy solution, but the reduction of a loan amount equates to a loss for someone else – a bank, pension fund, insurance company etc.   A reduction of only $25,000 on 12 million homes means another bailout of $300 billion – someone gets burned by this loss and our government does not have an unlimited ability to borrow money.

2. The social backlash and resentment from the 40 million households who have a mortgage but still have equity, as well as from the 24 million households that have no mortgage is going to be tremendous; the consequences will not be positive.

3. Every borrower who has a subprime or pay option arm loan was not a victim; I am sure some did not understand the terms of their loans and there were abuses, not to mention that many of these borrowers should never have been granted a mortgage approval in the first place.  However, most people of reasonable intelligence normally ask about the terms and details of their mortgage and are given numerous disclosures during the loan process and at the closing table.

Why should someone else pay for another’s carelessness with their financial affairs and failure to properly evaluate their actions?   There is plenty of blame to go around here, both on the borrowers part and certainly on the part of the lenders who knowingly made loans that they knew could not be repaid.

4. For a nation that has a tremendous debt burden on every level, loan mods could encourage debt repudiation on a massive level which will cause a further destruction of asset values on a scale too large to contain, which is what is already happening.   Every loan represents an asset to someone else; debt destruction and asset price destruction reinforce each other; the evaporation of wealth (assets) on a massive scale will not help anyone.

5. Many of the buyers of properties in the past 4 years purchased with 100% financing.  To the extent that they now have negative equity, what have they really lost?  They received a free call option on future price appreciation of the property that they bought. Now that the property didn’t go up in value, they are entitled to walk away from their loan obligation or simply default and then be given huge concessions?   I have seen many people that purchased a home with 100% financing come back a year or two later and then take out as much cash as possible with a new first or  second mortgage. My math puts these people way ahead of the game.

6. I have also seen many people do 100% cash out refinances in the past four years, often times using the money for trips,  new cars, consumer goods etc.  Many of these refinances occurred at the peak of the market meaning that they effectively sold their properties at peak prices.  For those now walking away or getting their loan balance reduced, it is their gain and the banks’ loss.

7. To modify the loan so that the borrower has a 34% front end debt ratio is extremely generous.  Most of the new first time homebuyers and mortgage refinances that I see approved have debt ratios above 34%, but the borrowers work hard, struggle and pay.  How is this equitable to them??

8. To reduce the principal on a pay option arm borrower back to his original principal or lower is equally inequitable to those borrowers who borrowed in a more conservative manner with a 30 year fixed rate loan.  Many of the pay option arms had initial payment rates based on a rate of  1% or 2% for a period of years; the real rate fully indexed was typically 6 or 7%,  but the borrower was allowed to pay a very low payment based on 1% and the balance of the interest that was due was added to his loan balance.  The pay option arm borrowers reap a windfall here since they effectively were given a 1% rate compared to the conservative borrower who took out a 30 year fixed rate and paid the full payment on a 6% mortgage.  Obviously, the pay option arm customer had a lot more cash left in his pocket at the end of each month; by my math they came out way ahead.

9. Many of the loan mods proposed will probably not work out since a significant number of the subprime and pay option arm loans were done with inflated stated income (liar loans).  Many of these types of loans would have to have a massive reduction in the loan balance for the borrower to have a comfortable payment since his income was never even close to what was needed to service the loan from day one.  The result would be a ridiculous situation whereby we are rewarding those who falsified their income to qualify for a loan.  How inequitable would this be for the financially responsible borrower who bought a home for $250,000 with a $50,000 down payment next door to the guy who also buys a $250,000 home, “states” his income to receive a 100% loan and now receives a loan reduction down to $150,000??

10. The impact of loan mods on future mortgage lending in this country will be incredible negative.  The government can subsidize rates and we can all pay for this, but investors who previously bought the loans or mortgage backed securities (which support the mortgage market) will either have no interest in this type of investment going forward or require a properly risk adjusted rate which is obviously going to be very high.  No one is going to lend out money when they face a substantial risk of large losses by having their original loan amount and interest rate reduced by a loan mod every time there is a price pullback in housing.  Mortgages have become and will remain an asset class of “extremely dubious value” (see 7. above).

11. Not Everyone Should Own a Home, Wall Street Journal, Janet Albrechtsen. In an excellent article that explains why Australian banks are not bankrupt entities as in America, the author points out the weaknesses in our banking system and the lack of responsible behavior by borrowers and lenders which helped propel us into the banking, housing and credit crisis.

Instead of prolonging our property market declines with constant costly bailouts, it may be wiser to follow the RTC example in the 90’s when the market was cleared by selling foreclosed properties for whatever bid was offered.  Anything will sell quickly at the right price.