Should we save borrowers in default? Is "loan modification" the magic pill to save the economy?

As we move into a new year and new administration, all the talk on the street is how to salvage the economy.  One plan floated is the modification of all loans in default to enable those borrowers to continue to make payments (lower payments from the restructuring) without being foreclosed on.  This is just what the chairwoman of the Federal Deposit Insurance Corp. (FDIC to me and you), Sheila Blair, suggests to fix the housing crisis.  She breaks with the current (Bush) administration with her plan to solve the economic crisis by putting bailout money directly into the hands of consumers rather than banks and the credit markets.  Her plan (similar to what the FDIC is already doing at IndyMac Bank since they took over there) is supported by many democratic members of congress.  Basically, the plan is to modify (by "modify" she means reduce interest rates, reduce principal amounts, extend loan terms, or use some other means to make loans more affordable for those in default) approximately 2.2 million loans for defaulting borrowers.  It is controversial, but does it have the potential to make an impact in the crisis.  She sat down for an interview with the Boston Globe this past week and I've selected a few key questions here that shed some light on the plan:

You were one of the first government officials to speak out about the housing crisis. Did you feel alone? 
I did feel a little out there. I just think the whole system broke down. It is hard to acknowledge that mistakes were made. The originators, the investors, the rating agencies, the regulators, and in many cases the borrowers made mistakes as well. There was a lot of push back. I think that was very unfortunate. We needed the industry to respond. The lack of willingness to initially acknowledge mistakes was unfortunate and has put us behind the curve. 

What was the tipping point when you started to have traction? 
The foreclosure rates became so problematic and housing declines so dramatic that everyone had to acknowledge we had a very serious problem already. At that point, a lot of the damage had already occurred. There are a lot of borrowers that still can be helped. It is in our collective economic interest to get these loans restructured. 

You still haven't been able to persuade the Bush administration to fund $25 billion for the FDIC program. Why not? 

I don't know. We've made our best case. We are supportive of all these measures. You really need to tackle the problem at the loan level. These are back- end efforts to assist the securitization markets without trying to fix the underlying problem. People are still looking for the perfect solution. It is not there. Our experts helped devise the [FDIC] program. We think it is a good program to get these loans modified. It has been a frustration for me that we haven't been able to come to grips with the underlying problem, which is the mortgages. 

We've heard housing experts say the reason servicers often foreclose rather than modify loans for struggling homeowners is because they have liability issues with investors. 
We don't buy that. I think that is an excuse. The legal standard is clear. The servicer has an obligation to maximize values to the securitization pools as a whole. So if the value of the modified loan exceeds the foreclosure value, the servicers are obliged to modify the loan. Our experience is that the vast majority of servicing contracts give servicers wide authority to modify the loan. 

In your much-praised plan to systematically modify loans of homeowners in default, you estimate that as many as 33 percent of borrowers will redefault even with affordable 30-year fixed loans. Why such a big percentage? 
We think that is a conservative number. I would suggest more in the teens. All too often, servicers don't verify current income when they modify a loan. We think we can get those redefault rates down because our program requires a truly affordable long-term modification. It requires verification of income and it also requires that the borrowers make six monthly payments under the modification before the loan would qualify for loss sharing. 

What do you tell people who feel that it's unfair that neighbors who signed up for bad loans through the FDIC program now get a 3 percent interest rate for five years? 

I would tell them I'm paying a higher rate on my own mortgage and I didn't get into this trouble either. We kept our house in Amherst. We have a 15-year fixed rate. At this point we need to look at what is in our best economic interest. Our overall economy cannot withstand millions more unnecessary foreclosures. 

 

What do I think?

1. Clearly the majority of the public is not in favor of bailing out "irresponsible borrowers" or people who got "liar loans" because it's "not fair".  Well, of course it's unfair to the people who paid their bills or didn't buy a home in the first place - in fact, it's completely and utterly unfair to the vast majority of people.  But rationally, what is the alternative....a worse situation for the whole economy, for everybody?  Guess what people - life isn't fair and if you haven't figured that out yet crawl back into your crib.
2. 2.2 million mortgages are only about 2% of property in the country (the Census Bureau estimates 108 million occupied properties in the US).  So, if we are only talking about 2% being a "problem" in the first place, is the bigger issue the creation of risky mortgage bonds, plus the other derivatives, options, and crappy risk models that actually amplifies the problem (read this article by Michael Lewis for more)?  Is finding better ways to fix the credit markets more important?  That's what the bailout money was originally intended to do.
3. This plan is not a cure-all, nor is entirely known that it will be effective.  One stat that jumps out at me: after modification it is expected that up to 33% of borrowers may still redefault.  Are we just delaying the inevitable?
4. So if we do try this, is there a way to make sure the modifications are done in a way to reduce re-default?  Mortgage servicers* were not set up to approve/disapprove loans in the first place and, in many cases, don't have the capacity to modify them effectively.  The mechanism for that must be in place and must be effective.
5. Can these modifications even stop price declines and stabilize the housing market in the short term?  Probably yes in many of the less hard hit areas, like Massachusetts, but I have my doubts about the states with huge problems, like California and Florida.  The problem is just too big, and many of the properties being foreclosed are not even occupied so loan modification is impossible.
6. Will banks/investors* be better off by not foreclosing as much.  Probably yes, given the hit they are taking by having to sell these distressed assets (see my post: Banks take average loss of $45K on foreclosed homes).
7. BUT - is modification in mortgage servicers* best interest?  Servicers choose to bring a home to foreclosure because they make more money than modifying a loan in many cases.  Plus the communication between investors and servicers is not exactly smooth, so a servicer may not know what an acceptable workout or modification would be until too late.  How are those problems going to be addressed to make sure this plan actually works?

Bottom line - we need to reduce foreclosures as one aspect of the recovery plan for the housing market and overall economy.  That helps reduce the inventory (or, supply side) problem in many areas.  I think loan modification as proposed by the FDIC is a way to do that fairly effectively (although unfairly).  There are many details that must be figured out first to create the desired impact though.  On the flip side, we also need to spur demand for buyers to jump back into the market and start purchasing homes as well.  This all says nothing of the general economy and business growth, or jobs, of course, but it's a start to improving the housing side at least.

Here's the real question though:  If we keep throwing money into this "economic rescue" will anyone really learn a lesson?  Will the banks learn that they got much too greedy and the risk models on their financial instruments were all wrong?  Will housing borrowers no longer have "lottery ticket" syndrome where they buy a house they cannot afford because "rates are so low" and "if I can't afford it, the government will help me"?

Clearly this one aspect of the bailout is not the "cure-all".  But it could have and probably will have a positive impact on the housing market and general economy, as one small part of a comprehensive economic rescue plan.  Unfortunately, right now there does not seem to be any cohesive "comprehensive thinking" behind the creation of a comprehensive plan.  No one agrees on the right way, yet I do still hold out hope that the Obama administration will step up with some true leadership and direct the recovery with conviction and authority. Most likely though, is that we'll just haphazardly throw money around until the recovery eventually occurs - some will help, some won't, most will be wasted.  I suppose that's the cost of doing business in America.

One thing I know for sure - the outcry over the reasons for our current economic collapse, and all sorts of talk about ways to prevent it in the future will continue for the next year or so, but our short attention span society will move on to the next big thing within a few years.  This mess will be all forgotten as we repeat mistakes over again, maybe not in the real estate and mortgage bond markets, but in some other "bubble" market that pops up.  The final question - is that just the price of progress and innovation?