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Monday, February 9, 2009

The Government Mandates Moral Hazards II

According to Michelle Malkin, the stimulus will mandate $50 billion for loan modifications.

Section 109(a) of the Emergency Economic Stabilization Act of 2008 (12 U.S.C. 5219) is amended—(1) by striking the last sentence;(2) by striking ‘‘To the extent’’ and insertingthe following:

‘‘(1) IN GENERAL.—To the extent’’; and(3) by adding at the end the following:

‘‘(2) LOAN MODIFICATIONS REQUIRED.—‘‘(A) IN GENERAL.—In addition to actions required under paragraph (1), the Secretary shall, not later than 15 days after the date of enactment of this paragraph, develop and implement a plan to
facilitate loan modifications to prevent avoidable mortgage loan foreclosures.

‘‘(B) FUNDING.—Of amounts made available under section 115 and not otherwise obligated, not less than $50,000,000,000, shall be made available to the Secretary for purposes of carrying out the mortgage loan modification plan required to be developed and implemented under this paragraph.

‘‘(C) CRITERIA.—The loan modification plan required by this paragraph may
incorporate the use of—768

‘‘(i) loan guarantees and credit enhancements;‘‘(ii) the reduction of loan principal amounts and interest rates;‘‘(iii) extension of mortgage loanterms; and‘‘(iv) any other similar mechanisms or combinations thereof, as determined appropriate by the Secretary.

This is the nightmare scenario that I have been writing about for months. Loan modifications, again, is when borrowers that can't afford their current mortgages get their terms modified into a loan that is affordable. As such, if you can't afford your mortgage, not to worry because a loan modification will make it more affordable.

First, it is very hard to understand what this $50 Billion will go for. Will it be an insurance policy to the banks, the way the FDIC has already done? If so, it will turn loan modifications into the new sub prime. With the government guaranteeing loan modifications, banks will rush out to get as many done as possible. That's because if the government is guaranteeing a loan modification there is no longer a risk that a borrower will go bad again.

So far, the banks have been reluctant to turn this into the cottage industry that sub prime was because they realize that these borrowers are a huge risk to go bad again. The early data supports the banks' fears.

Many borrowers who received help with mortgage modifications earlier this year tended to re-default on their payments, a top U.S. banking regulator said on Monday, citing recent data.

"The results, I confess, were somewhat surprising, and not in a good way," John Dugan, head of the U.S. Office of the Comptroller of the Currency, said in prepared remarks for a U.S. housing forum.

"Put simply, it shows that over half of mortgage modifications seemed not to be working after six months."

In other words, a startling number of loan modifications wind up defaulting. As such, banks are reluctant to make loan modifications a standard practice. The government has no such fears and the government is willing to back $50 billion worth of loan modifications.

Of course, here is the economy reality. $50 billion is a drop in the bucket as far as trying to stem the tide of foreclosures. In other words, this $50 billion commitment will do little to stabilize housing. It will do little to stop the bleeding on foreclosures. In order to make any dent, $50 billion will need to be multiplied exponentially. The number would need to be more like $500 billion in order to have any real effect.

As such, what this will do is make all sorts of enterprising mortgage professionals very wealthy. That's because mortgage pros will find out about this and attempt to take advantage of this by turning their attention to loan modifications. $50 billion maybe small to the overall economy, but it is quite a lot to the industry itself. It will also prop up all sorts of borrowers that got in over their heads. It will allow banks to take a small portion of their bad assets and modify them. In other words, this will be a$50 billion distribution of wealth from the tax payers at large to certain folks that are either in the right place or are smart enough to take advantage.

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