Loan Modifcations: How Bad Will It Get

Here is a proposal that should encapsulate just how bad things will get.

I want to float an interesting mortgage rescue idea from the National Community Reinvestment Coalition. The group’s president and CEO, John Taylor, will advocate it before the House Financial Services Committee this afternoon.

We all know that the biggest roadblock to mortgage modification is and has been the loan servicer and that servicer’s responsibility to its investors. So many loans during the housing boom were pooled and sold off to investors that it became close to impossible for the servicers of those pools to get permission across the board to change the terms of individual loans.

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Taylor and the NCRC are proposing a new government program, using TARP money, whereby the government would “use its power of eminent domain to take troubled properties/loans from mortgage servicers and lenders, so large numbers of loans could be modified, writing down principal and interest rates. The loans would then be re-sold to the private market.”

The government would buy these loans at a “steep discount.” Eminent domain allows the government to take an asset where a public purpose is served, and it requires that they pay the investor the “fair market value” for it. NCRC claims the fair market value would be about 30-50 percent of the current loan value.

NCRC argues, “Discounting the purchase of these loans would strike a balance between assisting homeowners and ensuring that lenders, servicers and securitizers are not rewarded for financing and servicing predatory and price-inflated loans.” That discounted price would then “be sufficient to write down the loan balance of millions of loans such that they can be permanently refinanced or modified to ensure long-term sustainability.”

So, here is a brief summary. First, again, the process of loan modifications is a process by which banks renegotiate a loan for a borrower that can't make the payments on their current loan. In other words, if you took out a loan you can't afford, never fear, the process of loan modifications will save you from yourself.

One of the main reasons that loan modifications are still not more prevalent is because the entity you speak with is not the entity that holds your loan. You, the borrower, are speaking with the loan servicer. This is a bank that has the responsibility of collecting your monthly check and maintaining your account. It is the end investor that has pooled your loan with others and turned those loans into a bond that ultimately owns your loan. Since, ultimately, it is the end investor that must agree to a loan modification, the process hasn't taken off as much as some would like.

As such, this plan, that will be presented to Congress, will alleviate that. Congress will impose eminent domain, normally reserved for private property. (fortunately, I don't see anyway that calling a mortgage real estate will pass any legal muster and thus, this particular idea will unlikely become law) In this case, the Congress will seize private mortgages. They will give "fair market value" which the author proclaims will be 30-50 cents on the dollar. Since the government will claim eminent domain, the banks will have no choice but to comply. The banks will take a major bath. Then, the government will not only give these borrowers a brand new mortgage in which they owe anywhere from 3-50% of what they used to owe, but they will give them a more attractive rate.

Then, the government will pool these mortgages together and sell them off into the private market as bonds.

Let's just count the ways that this plan is disastrous. Borrowers took out mortgages they couldn't afford. Now, they are rewarded with a brand new mortgage that is significantly less than what they owed. It is so much less that they can even sell the property and make a profit. How is that for a moral hazard? Furthermore, all of these troubled borrowers will be pooled together and turned into bonds? Now, how in the world are these bonds to be valued? There is no market for such borrowers? There is no history. What exactly should the rate be for a pool of bad borrowers that now owe much less than they used to? On the one hand, they've proven they can't be trusted to pay their bills. On the other hand, their bills are so much less now. No one knows and so, anyone that buys these bonds is committing financial malfeasance. Such a bond should have absolutely no takers as such a bond can't possibly be valued in any reasonable way. Yet, after the government rewards troubled borrowers with loans no good borrower could possibly get, they will then send all these borrowers back into the private market in the form of bonds.

Since prior mortgage lates lead to an exponentially higher chance of future mortgage lates, there's absolutely no doubt that these bonds will experience far too high a default rate and thus cause future harm to the financial system. Of course, this ridiculous and hokey idea will get a full hearing in front of the Senate's Finance Committee. It's one of the first in a long line of hokey ideas that will eventually make loan modifications an industry standard. Eventually, the whole world will come to view loan modifications as the nightmare end of government interference. Until then, the government will push them on the system until its effects blow the system up. I, apparently, am the lonely voice speaking out about just how dangerous it all is.