My Loan Modification Nightmare Nears

CNBC has a story today that is frightening me.

The Obama administration is hammering out a program to subsidize mortgage payments for troubled homeowners who have gone through a standardized re-appraisal and affordability test, sources familiar with the plan said on Thursday.

...

I've talked to all the major servicers—both the big bank ones and the big independent ones—and they are all ready to go, they're chomping at the bit," Lockhart, the director of the Federal Housing Finance Agency, said. "The other thing they're asking for standardization."

...

Lockhart said that policymakers are eager to prevent a large drop in home values from their current, deflated levels.

Again, the process of loan modifications is a process in which borrowers that can't afford their mortgage have it "modified" to one they can afford. In other words, if you took on a mortgage you can't afford, not to worry, you may be qualified for a loan modification. I remember seeing a loan modification in which the borrower received 4% for five years, 6% for two more, and 6.75% for the remaining 23 years. The industry average falls at right around 5% for the life of the mortgage. That's not a bad deal considering you only get it BECAUSE you can't afford your current one. (or as you will see as long as you present a strong enough case that you can't)

Now, this may still work out to be all right. I have said that loan modifications are in desperate need of regulations. This plan may provide that, however, it appears that rather than regulations it will provide guidelines. This may seem like a distinction without a difference. It may still be but on the other hand, this plan could turn out to become a nightmare. That's because there is a big difference between regulating an industry, which I think is desperately needed, and standardizing the process, which is what the government is planning on doing.

Once again, we have scant details so far. From what I have gathered, the federal government will draw up the standards for qualifying for these modifications. In other words, the government will create the guidelines for qualifying for a loan modification.

Of course, I haven't seen the guidelines, and I hope they are very strict, however strict guidelines will have a tension with the overall goal...to save as many as possible from foreclosure. Once loan modifications become standardized all that's left is for brokers and borrowers to manipulate the system.

If you think I am being cynical, then just keep in mind that this is exactly how the sub prime crisis came about. Once standards were created, everyone just manipulated them. If, ultimately, what needs to happen is for a loan modification to meet a set of guidelines, then soon everyone will have a myopic goal of doing that. Once that becomes the goal, then all sorts of folks will wind up with modified loans no matter whether they deserve them or not. That's pretty much how the sub prime crisis happened as well.

This model will be based on the nebulous concept of "hardship". In other words, the government will set up a set of standards to measure a borrower's hardship. The government will quantify a person's hard luck story. There is plenty of room for manipulation here. Any small business owner can always claim a serious reduction in income. Anyone on commission can hoard commissions to make their income look smaller in order to qualify. Anyone with a variable rate immediately qualifies. Any drop in income also immediately qualifies.

Many of these things can be easily manipulated by unscrupulous borrowers and mortgage professionals. If you think I am cynical or paranoid, just keep in mind that we are now on the brink of allowing loan modifications to explode as an industry and the players will all be the same folks that caused the mortgage crisis: the borrowers, the banks, and the mortgage brokers. The folks that will be most qualified for these new loan modifications will be current sub prime borrowers. It will be sub prime banks in charge of the loan modifications. Of course, the pros putting these two folks together will likely be former mortgage brokers, most of which have been moving to loan modifications.

Finally, I predicted that this process would soon set off a class war between those with good credit, who would have trouble qualifying for a loan modification, and those that do. If this process becomes standardized, this would mean it would become large enough to set off the mortgage class war I predicted.