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Monday, January 19, 2009

Some Nightmare Scenarios of Obama and Loan Modifications

The most common objection to some of my doom and gloom predictions to the process of loan modifications come from those that point out that banks have so far been reluctant to do many loan modifications. There needs to be some perspective on this. It's true that banks haven't done all that many loan modifications at least compared to how many applications there have been. That said, prior to six months ago or so, banks would do a handful of loan modifications yearly. Now, in the last six months, they have received millions of requests for loan modifications. While they have denied most requests, there is no doubt that banks have approved exponentially greater loan modifications in the last half year than they had at any time prior.

Banks have been reluctant, in my opinion, because at their core they understand how ludicrous loan modifications are. Again, loan modifications occur when a borrower is struggling to make their mortgage payment and the bank re negotiates them into a loan that is more affordable. In other words, if you have a loan you can't afford, not to worry, because a loan modification will save you.

Now, while banks are reluctant to do too many loan modifications, the government is amped up. That's because the government, at most levels, is determined to stop the rising tide of foreclosures at any cost. Loan modifications offer one of the best options to any politician that has a myopic belief that foreclosures must be stopped at all costs. That's because, they offer an easy alternative that is already available. Other options would include drafting new legislation. It would mean creating new government bureaucracy, and it would mean that government would need to manage it all. Now, ironically enough, politicians will likely find that making loan modifications play a significant role in confronting foreclosures.

Still, I believe that Obama and the Democratic legislature will draft all sorts of legislation that will either encourage banks to do more loan modifications or even force them to do more. I see two potential pieces of legislation that will create nightmare scenarios.

First, Obama could nationalize what they did in California. In California, a borrower can't be foreclosed on until they receive a loan modification. Only if that same borrower goes bad on the new modified loan can they then be foreclosed on. This would create a nightmare that is simply unquantifiable. If someone falls behind on their loan, they know they can't be foreclosed on. They know that such a position immediately entitles them to get a better deal. This creates all sorts of incentive for those on time to fall behind and those behind to simply stop paying. It encourages the worst kind of behavior in borrowers. If this were implemented, we would likely see all sorts of folks fall behind or fall further behind in order to get a better deal. Besides maintaining good credit, borrowers would have no motivation whatsoever to stay current on their mortgages. As such, any borrower who's credit is already in jeopardy would have little if any motivation to stay on time. Keep in mind, in this scenario, falling behind on your mortgage means you are ENTITLED to a new mortgage with better terms.

The second option is actually a lot more likely. Last week, I wrote about a proposal that will get a hearing in front of Congress. Obama might try and use the TARP money or other bailout money to do something similar to the proposal. In the proposal, the federal government would seize bad debt, renegotiate it themselves, and package it themselves and sell them as bonds. This is likely far too heavy handed to pass Constitutional mustard. As such, Obama might instead set aside tens of billions in either TARP or stimulus money to do something similar. Rather than forcing banks to give up bad debt, he would encourage banks to give up the debt by offering them a way to remove it from their books. The plan would work something like this. If banks did a loan modification for a troubled borrower, the federal government would then immediately buy that new loan from the bank at an amount that would be worthwhile to the bank. Such a deal would allow banks to instantaneously remove their "toxic debt", and it would allow Obama to stop foreclosures cold.

Banks are reluctant to hold onto loan modifications because they know that in general a bunch of modified loans are even worse than just foreclosing. Now, if Obama were to offer banks a way to modify and remove that paper, then that would remove all qualms banks have in doing them. That would set off a frenzy of modifications because the money would obviously not be endless. Furthermore, all rules would go away. Banks have almost no care about who gets modified. All they are trying to do is remove bad assets from their books. If someone is behind on their mortgage, then they could be removed through this modification. Since only mortgages that are behind would be considered, it would also instantaneously encourage every borrower to fall behind on their mortgage. How many would fall behind is any one's guess? I would suspect that just as many people would fall behind in order to qualify as would be saved from foreclosure through this process.

Then, Obama would have to decide what to do with all of these loans. The government could decide to become the bank for all of these loans similar to FDR's Homeowner's Loan Corporation. Of course, such a move would require creating another massive government bureaucracy. Thousands of people would be required to organize and administrate these loans. All of the functions of a bank would have to be done and on a very mass scale. The other option that Obama would have is to package these loans together and sell them off as bonds. This would prove even more tricky. It would require an even larger bureaucracy. Not only would all requirements of a bank be necessary but all requirements of a loan securitizer be necessary. Such a department would rival the biggest in our bureaucracy. It would also be next to impossible to price. These people would receive rates they didn't deserve. As such, the pricing model doesn't exist.

In either scenario, there is a real possibility that millions of homeowners would be motivated to fall behind on their mortgage specifically because that's how they qualify for this process. Both scenarios would ensure that loan modifications would become industry standards. Both scenarios ensure that loan modifications would be done on a mass scale with almost no oversight. Both would create the sort of nightmare I have been writing about regarding loan modifications. Watch how the Obama administration treats this tool to see just how bad things will get.

8 comments:

Frank In Dixie said...

Your arguments have no basis in fact from a Main street point of view.
Please provide some documentation to support your statement, "Banks are
reluctant to hold onto loan modifications because they know that in general
a bunch of modified loans are even worse than just foreclosing." At $50K or
more per foreclosure, it costs a bank far less to modify than to foreclose.
Banks are reluctant to modify because they know the government will
absolve them of any wrong doing and buy their bad debt, plain and simple.

Your views, although supported by many in D.C., including even the
departing Hank Paulson, appear to be totally supportive of the gross
negligence and even blatant fraud perpetrated on millions of Americans who
were given loans that even law professors don’t understand. These products
were invented out of the sheer desire to make as much money as possible in
the shortest amount of time by shrewd financiers with a devil may care
attitude about the future.

To lay the blame of this financial Armageddon solely at the feet of the
millions of plumbers, dental assistants, and auto mechanics who simply
wanted a roof over their heads at an affordable price displays a total
disconnect from the reality just beyond the Hill of D.C., and just outside of
Wall street. Your arguments would be downright knee slapping laughable if
the aforementioned folks weren’t being put out on the curb like so many
bags of garbage, while at the same time the management of these financial
institutions curbing them are parachuting left and right with millions of
dollars. Taxpayer dollars I might add. The very same dollars that the
plumber and mechanic who are now out on the curb paid to the government
in the first place. Having to financially support the very bank that put you
and your family out on the street is somewhat akin to being forced to dig
your own grave.

Your heading reads, “The nine most terrifying words in the English
language are 'I'm from the government and I'm here to help.” I would prefer
that any day to, “Have I got a product for you! Just sign and initial these 75
pages and move right in to your dream home! You don’t even have to put
any money down, isn’t it great?”

mike volpe said...

Frank,

it's ironic that you claim that my arguments have "no basis in fact", because nothing you said was backed up by anything near a fact.

First, banks are reluctant to do loan modifications. Second, the first data from modifications has come out from the MBA and it is not very good. About half of loan modifications are now in default.

http://www.cnbc.com/id/28112901

It's true that a loan mod is better than a foreclosure as long as the modified loan is paid back. Of course, the reason that banks didn't do many loan modifications is because they simply didn't believe that most would be paid back.

There are plenty of other problems with loan modifications. You don't know if the borrower will pay back the new modified loan. Furthermore, once the public at large learns that a bank provides this service, many more will want it and many will fall behind to get it.

As for the rest of your rant, I have been in mortgages for seven years and loans are not so hard that financial professionals can't understand them. While you claim that millions of people were duped by sophisticated mortgages, you provide no example.

If a multi hundred thousand dollar loan was too complicated for someone to understand, why did they sign the documents? Frankly, there are plenty of loans out there that are very simple. For instance, there is the 30 year fixed. This loan has the same payment and rate for thirty years and it never changes. Many borrowers demand this loan because they aren't sophisticated enough to understand other loans. Maybe all of these borrowers should have heeded such warnings.

Another somewhat simple loan is the ADJUSTABLE RATE MORTGAGE. Now, if your claim is that financial pros couldn't understand this loan, that is nonsense. If you claim a borrower didn't know that an ADJUSTABLE rate mortgage, adusted, that is their fault.

The most complicated loan I know is the option arm. Frankly, any borrower that signed up for this loan without understanding all the consequences has to bear some responsibility. Yet, even this loan is understood by financial wizards.

Frankly, I don't just blame the borrower. Lots of people are responsible. The difference between me and you is that I include the borrower in those responsible.

Frank In Dixie said...

Mike,

The entire first half of your rebuttal examines the fact that around half of all loan
modifications are back in default. I don’t argue this point. However, I will argue that the
data is skewed when you consider that there is no baseline from which to draw
conclusions as to the efficacy of the individual modifications. Since there is no
modification formula presently in practice, no agreed upon standard, who can know
whether or not the terms of these modifications were sustainable for the individual
homeowner’s financial situation?

I have a friend who lost his job and went into default. He was able to find other work,
only at much less money than his previous employment. He managed to pull his house
back out of foreclosure, but still needed a modification in order to keep his home. After
nine months of being told that he would get a modification from Countrywide, they
finally sent him the paperwork to sign. They modified his mortgage alright, only they
modified the monthly payment upwards, at the same time adding $7,500 in fees to the
principal. BTW, this was a take it or leave it proposal....take it and keep your house, leave
it and we foreclose. I’m sure this incident is not unique, and yet it too would show up as
more skewing of the above mentioned data.

You state that you’ve been in mortgages for seven years. I’m not sure if that means that
you’ve been in the mortgage industry for seven years, or that you’ve had a mortgage for
seven years. I would guess it’s the latter if you’re unaware of the abusive practices that
have been going on for quite some time by lenders and brokers alike, and that most
people knowledgeable about the current state of affairs believe are to blame for the
worldwide pickle we’re in. IMO, you tilt the blame exponentially on the side of the
borrower. The fact of the matter is that for many people, these are complicated
documents, and many rely on these so called professionals to help steer them into a
mortgage that will serve them well. A sad but true study just recently reported that 1 out
of 7 Americans are illiterate. I wonder how many subprimes were sold to these poor
folks? Pennsylvania defines a subprime mortgage as follows, “Subprime means, in effect,
breaking the traditional rules governing qualification for a mortgage, as well as
structuring payments in a way that almost seems guaranteed to put the borrower in a bind
at some point.” Hmmm, not too ambiguous as to who’s at fault in PA.

Contrary to your belief, many banks aren’t writing modifications simply because the
products they sold no longer exist in a recognizable form, and have been sold to investors
who don’t want to see their investments go down any further. That’s understandable, I
don’t like when that happens either. But until the reality sets in that this credit freeze isn’t
going to thaw until this issue is dealt on a wholesale level, as painful as that may seem,
we’re in a stalemate, and nothing will change save for the further deterioration of world
markets and an increase in foreclosures due now not to subprime mortgages, but to
increasing job losses. It’s a nasty feedback loop.

The good news is that some banks are starting to see the wisdom in Sheila Bair’s
common sense proposal that includes meaningful modification terms, ones that don’t just
look good on paper, but that get to the heart of the matter i.e. through principal write
downs, adjustment linked to ones ability to repay, reduction in interest rates as well as a
reamortization of the loan out to 40 years. IMHO, only through a combination of
substantial changes like these will we escape from the event horizon of this immense
financial black hole we’re peering into.

BTW, I don’t consider these back and forths as rants so much, as you suggested in your
follow up to me. I look at them more as meaningful discussions in which we just happen
to disagree. You’re looking down, and I’m looking up, but we’re both staring at the same
problem. I suspect that these two ideologies will have to meet somewhere in the middle if
we’re ever going to work this thing out. Just a thought.

Peace,

Frank In Dixie

mike volpe said...

Frank, with all due respect, if half of loan modifications are back in default in only six months, that data speaks for itself. You can true and play all the word games you want, but clearly that data indicates one thing and one thing only, loan modifications are a horrible idea.

A colleague just came into my office after recommending that a borrower start to miss payments in order to get a loan modification. This is what will see on a grander scale the more these modifications are pushed by the government and other forces.

They are a horrible idea. They reward exactly the sort of behavior that should be punished. Why should someone be rewarded with a better rate because they miss their mortgage payment? Exactly what sort of behavior do you think this encourages?

Call this what you want. I have been in this business for seven years and what I see with loan mods may wind up being worse than what I saw in sub prime.

There is no sensible solution to loan modifications besides making them as rare as possible.

Anyone can come up with a hard luck story like your friend and then they will receive rates the market couldn't give them. That is encouraging the worst sort of behavior. The more people learn about loan modifications the more it will be manipulated and it will be manipulated by the same folks that manipulated sub prime.

I do notice that after your bellicose rant initially, you calmed down. Maybe, you figured out that I do know what I am talking about.

You can comment anytime, but be prepared to defend what you say because I love any debate.

Frank In Dixie said...

Mike,

If you simply insert the word bank into every spot where you write borrower, you’ll see
my point exactly.
"The troubled asset relief program is a horrible idea. TARP rewards exactly the sort of
behavior that should be punished. Why should a bad bank be rewarded with billions of
taxpayer’s dollars because they gambled big and lost? Exactly what sort of behavior do
you think this encourages?"

You wrote, “Maybe, you figured out that I do know what I am talking about.” I’m sorry
Mike, I didn’t figure that one out. But I did figure out that we will never see eye to eye on
this, and that’s OK by me.
Good luck to you,
Frank In Dixie

mike volpe said...

I have in fact spoken out against TARP and I do think it is a horrible idea. I do think it rewards the very behavior that should be punished.

yet, this piece is about loan modifications and so I don't introduce TARP. You will find that I am very consistent on the issue of moral hazards. You just have only read this piece and none of my others and so you assume things that aren't so.

Frank In Dixie said...

Mike,
Although I agree that this discussion is about modifications and not TARP, my viewpoint
here from the very beginning has been that the problem originated with bad lending
practices, moreso than bad borrowers, therefore mentioning TARP as a way of rewarding
bad banks seems in order.
Danger: Skewed Figures Ahead! From the Star Tribune:
“But counselors at several foreclosure prevention agencies in Minnesota, as well as
several new studies, say those numbers are misleading (successful modification
numbers), with the vast majority of modifications still leaving homeowners with
mortgages they can't afford. Counselors say many modified mortgages still have the same
esoteric terms that sunk so many subprime borrowers: "interest-only" and "balloon"
payments, as well as scheduled interest rate increases -- now called "stepped rates"
instead of "adjustable rates."
snip
“Of 21,000 modifications last November, 68 percent wrapped missed payments and other
charges into the principal, according to Alan White, the researcher and a law professor at
Valparaiso University School of Law in Indiana. That added about $11,000 to the average
$210,000 mortgage and led to higher monthly payments in 45 percent of cases, White
said.”
http://www.startribune.com/business/37734799.html
Mike, these numbers pretty much negate the data about how many modifications renter
default. If 55% re-enter default within six months, but 45% of modifications are actually
causing payments to rise, then I would suggest throwing 45% of the modifications out
right off the bat. Therefore, 10% re-enter default after six months...not a bad rate at all.
Frank In Dixie

mike volpe said...

If you think that after six months that ten percent of these loans are back in default, that this is a good number then you are out of your mind.

Like I said, I don't agree with TARP or anything that rewards bad behavior, known as a moral hazard.

This was an equal partnership between bad lending practices and irresponsible borrowers. The idea that you purport that lenders took advantage of naive borrowers that had no idea what was going on is simply devoid of reality. It simply isn't true.

Nothing of what you say on this matter can you back up with anything near a fact.