President Obama's Troubling Loan Modification Philosophy

The President will unveil the entire plan tomorrow, but the administration gave us a preview today.

President Obama’s plan to reduce the flood of home foreclosures will include a mix of government inducements and new pressure on lenders to reduce monthly payments for borrowers at risk of losing their houses, according to people knowledgeable about the administration’s thinking.

The plan, to be announced Wednesday, is expected to include government subsidies for reducing a borrower’s interest rate, which a lender would have to match with its own money.But officials cautioned that subsidies for lower interest rates would not in themselves help many troubled homeowners, because lenders were still likely to view many of those borrowers as bad risks and refuse to restructure their loans. As a result, they have been casting about for sticks as well as carrots to persuade the lenders to take part.

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That change, sometimes described as a mortgage “cram-down,” would greatly increase the bargaining power of borrowers in negotiating new loan terms with their lenders. The banking industry has vehemently opposed it, warning that investors will stop financing mortgages if they know that a judge can unilaterally change the terms at a later date.

But Mr. Obama and Democratic leaders in Congress support the change, and Democratic lawmakers had already been planning to attach such a measure to a catch-all spending bill that Congress will soon have to pass to keep the government running.

Now, the Obama administration is entirely one sided in their philosophy toward loan modifications. They appear to have a myopic goal of making it as easy as possible for anyone in trouble to get a loan modification. They will use a combination of carrots and sticks to make sure to open up loan modifications to as many people that are in trouble as possible.

I am of the opinion that loan modifications need to be regulated so that only those that deserve them get them. Of course, this is one of those things that is easier said than done. A loan modification is done when a borrower can't afford their current mortgage. The bank then modifies the loan. As you can see, such a process is open to abuse.

If the Obama administration is determined to make them as open as possible, they will be abused. The Obama administration will subsidize these modifications by providing some of the lost money to the bank. The Obama administration is also likely to give bankruptcy judges more authority to modify loans themselves. Such an action would encourage banks even more to do loan modifications because at least then, they would control the terms.

Given what the Obama administration has said so far, it appears clear that they are very keen on making loan modifications very available. Yet, it is also just as clear that they have little intention to make sure that the process will be abused. As such, you have my nightmare. We will have another open process in which sub prime banks are encouraged to take advantage of new mortgage tools, in this case loan modifications. The very same sub prime borrowers will be the main beneficiaries of the process. To top it off, most mortgage brokers will move to loan modifications. As such, the same players will wreck havoc on a new process that will also have few rules to limit entrance. The new sub prime crisis is upon us.