Assessing the President's Loan Modification Plan

The White House rolled out their mortgage bailout plan today. Some have called it detailed but in fact, the details I was looking for continue to be missing and apparently aren't revealing until March.

Asked why the cost had jumped to $75 billion from initial talk of a $50 billion effort, Geithner said, "We think that's necessary to make a program like this work."

And he said relief would be almost instantaneous, basically as soon as rules are published March 4. "You'll start to see the effects quite quickly", Geithner said. Sheila Bair, chairman of the Federal Deposit Insurance Corporation, said previous efforts had largely flopped.

"We've not attacked the problem at the core," she told reporters. "We are woefully behind the curve."

The devil in such a plan is in the detail. We won't have those until March 4th. These guidelines have to set a delicate balance between helping those that truly played by the rules, without being too cumbersome, while making sure this doesn't become a boondoggle. I believe that is impossible. Yet, the President still hasn't revealed how he plans on doing that. There is contradiction in terms between loan modifications and "playing by the rules" If you truly played by the rules, you have no use or need for loan modifications. If you truly need a loan modification it is because you can't afford your current mortgage. Despite President Obama's rhetoric, if you can't afford your mortgage that is ultimately your own responsibility.

The first problem I have with this plan is the numbers. President Obama is committing $75 billion to this program. He is committing to saving 7 to 9 million homes. If the average value of each of these loans were $100,000, that is a total real estate value of $700 billion (if you only save 7 million homeowners). Of course, it isn't. I would say that the average value would be more like $300,000. Does anyone think it will only take $75 billion worth of government subsidies to save 2 plus trillion Dollars worth of real estate.

Next, the program encourages the wrong behavior.

Pay for Success” Incentives to Servicers: Servicers will receive an up-front fee of $1,000 for each eligible modification meeting guidelines established under this initiative. They will also receive “pay for success” fees – awarded monthly as long as the borrower stays current on the loan – of up to $1,000 each year for three years.

Incentives to Help Borrowers Stay Current: To provide an extra incentive for borrowers to keep paying on time, the initiative will provide a monthly balance reduction payment that goes straight towards reducing the principal balance of the mortgage loan. As long as a borrower stays current on his or her loan, he or she can get up to $1,000 each year for five years.
Reaching Borrowers Early: To keep lenders focused on reaching borrowers who are trying their best to stay current on their mortgages, an incentive payment of $500 will be paid to servicers, and an incentive payment of $1,500 will be paid to mortgage holders, if they modify at-risk loans before the borrower falls behind.

What this incentive does in encourage volume and it also encourages modifications of those most likely to repay. Encouraging volume doesn't necessarily encourage modifying those most deserving. Mortgage brokers and banks focus on one thing and one thing only in a transaction, figuring out a way for that transaction to fit guidelines. This plan will pay the bank $1000 for every loan that is modified that "fits guidelines". Of course, we still don't know what these guidelines are (that won't be revealed until March 4th), but as soon as that is revealed, banks and brokers will work to find as many loans as possible that fit guidelines. This opens up the process to fraud and abuse.

Second, it pays more to those borrowers that are on time with their modified loans. Of course, it is exactly those borrowers that are upside down and in deep that are most likely to fall behind again. As such, banks will be encouraged to give loans to those that are significantly more likely to be able to repay their current loan than they are to those that definitely can't repay their current loan.

Then, there is vague language that is problematic. The plan says that no one will qualify who's modified loan will cost the government more than foreclosing. Well, the government will help to subsidize loans to get their debt to income to 38%. These loans, I presume, are for thirty years. Subsidizing loans for thirty years would almost always be more expensive than allowing them to be foreclosed.

Finally, the Treasury says that they will set limits on these modifications. The rates won't fall below 2%. Now, let's think about that. This means these modified loans could get rates of just over 2%. Currently, someone with perfect credit will get a mortgage of just over 5%. Yet, someone struggling to make their payment may have their struggles be rewarded with a 2.5% rate? Does that sound fair or reasonable? Does such a dynamic not lead to all sorts of unintended consequences?