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Wednesday, November 26, 2008

Examining the Nightmare of a Corrupt and Speculative Loan Modification Market

Introduction: If you are new to the process of loan modifications, here is a quick run down. This is the process by which banks create a new loan for borrowers that are struggling to pay their current loan. Terms and rates are set not by credit worthiness but frankly by credit unworthiness. In such cases, borrowers have loans they can't afford. Banks adjust the loan and make the payment something they can afford.

I have written often now about loan modifcations. I have predicted an upcoming mortgage class war, and I have predicted how the process would be corrupted. Now, it's time to predict what exactly would be the outcome if I am right.

If I am right, then two things will happen and each will involve unqualified borrowers receiving these loan modifications. First, unqualified borrowers will get brand new and much better loans only to screw that up as well. These folks will now still need to be foreclosed on only this would come after their original foreclosure was halted in order for their loan to be modified. Two things would happen as a result of this. First, the real estate market would appear to be stabilized because all of these loans were modified only to have it blow up again a couple years later. Second, and much more destructive, these newly modified loans would often be guaranteed by the federal government as the FDIC has. By guaranteeing these loan modifications, the FDIC also assumes that no more than 1% will eventually go bad. I expect that number to be dramatically worse. Most folks that get a loan modification already have at least one mortgage late. Those with a mortgage late are dramatically more likely to be late on their mortgage in the future, and thus, the FDIC is now guaranteeing loans on folks with a significantly higher risk profile than those that winds up paying their loan back at least 99% of the time. This will likely cause the FDIC itself to be in need of a bailout, and thus, the U.S. Treasury would wind up borrowing even more.

An even more troubling outcome will be millions of people who have no real need for a loan modification also being able to get one. These will be millions of borrowers that are perfectly capable of paying their current mortgage that will game the system to make themselves appear needy and get a below market mortgage as a result. The average rate for a loan modification is about 5% (from those I have spoken with) but they can be as low as 3% and lower. Now, millions of perfectly capable borrowers will hold onto a mortgage that the bank can't sell. (since they'd all be below market rates) Furthermore, let's imagine the economy recovers a bit and interest rates go up. Now, banks will hold onto millions of mortgages that have the potential of losing them money in that environment. If they are holding onto millions of mortgages at 3% and below and money market and savings rates happen to go up enough, these banks will now be upside down on billions of Dollars worth of debts. Banks make money by creating a spread between the money deposited in their banks and the money they lend with those deposits. If mortgage rates were to go up to 9% or more, savings and money market rates could easily be above 3%. Banks would once again face a liquidity and capitalization crisis.

As such, if I am right, then in the next two to five years we will unleash an economic terror possibly even worse than what has been unleashed now.

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