Loan Modifications and Moral Hazards

Loan modifications will be a term that will soon become a part of the mainstream of the nation's lexicon, I predict. Currently, it is the dirty little secret of the mortgage industry that banks would rather keep quiet. Yet, between the culmination of events as well as aggressive government action, soon everyone will know what they can do if they are late and don't want to be foreclosed on.

A new law in California has cut down the number of foreclosures significantly.

Los Angeles home foreclosures fell sharply in October from September as a new California law came into effect, while the number of foreclosures in Miami continued to grow at a slower rate, real estate research website PropertyShark.com said Tuesday.

The number of newly scheduled auctions on foreclosed properties in Los Angeles county fell 51 percent, the greatest monthly decline in two years.

The law, passed July 8, requires lenders to contact homeowners and explore options to avoid foreclosure before initiating the process. Some sections of the law became effective Sept 8.Its implementation accounted for most of the decline, to 2,389, in the number of newly scheduled auctions foreclosures in Los Angeles County, said PropertyShark.com Chief Executive Bill Staniford.

This law demands that banks offer loan modifications to borrowers prior to beginning foreclosure preceedings. What is a loan modification? It is when a bank re negotiates the terms of a loan with a borrower struggling to make the payment on their mortgage.

In loan modifications borrowers often have variable rates frozen, rates cut, and sometimes they have mortgage balances reduced entirely. In other words, because borrowers took on too much debt, they are rewarded with artificially better terms. It is essentially what John McCain proposed only in this case the banks that are holding the loans take it upon themselves to improve the terms of struggling borrowers.

Of course, there are limits. Borrowers must truly be struggling, and this must be the result of normal circumstances. For instance, if a borrower is attempting to do a loan modification and the bank notices they recently bought a new BMW, they won't modify. Of course, banks will only notice large purchases if they are on the credit report. If borrowers are struggling but it is due to going out too much or spending too much money day to day, that won't be known by the bank.

The biggest problem is that loan modifications have a built in moral hazard. Borrowers struggling to make their mortgage payment will be rewarded with better terms. All this will do is encourage more borrowers to struggle to make their mortgage payment. Loan modifications are not new. They have been around for decades, however banks kept them under wraps. They normally required a lawyer to negotiate on the behalf of the borrower, and they never advertised their existence. As such, most folks didn't know this was an option.

Now, with foreclosures on the rise, banks are looking at any alternative to stem the tide. Loan modifications is an option many are turning to. Banks are beginning to advertise this option more aggressively. On top of this, states and municipalities, like California, are also looking to slow down foreclosures. As such, laws like the one in California are likely to pop up more and more. Soon, everyone will know what a loan modification is, and all it will do is encourage even more irresponisble borrowing.