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Friday, November 14, 2008

The FDIC Insures Moral Hazards

Any doubt that the new rage in mortgages will be "loan modifications have been laid to rest with this announcement from the FDIC.

Although foreclosures are costly to lenders, borrowers and communities, the pace of loan modifications continues to be extremely slow (around 4 percent of seriously delinquent loans each month). It is imperative to provide incentives to achieve a sufficient scale in loan modifications to stem the reductions in housing prices and rising foreclosures. Modifications should be provided using a systematic and sustainable process.

The FDIC has initiated a systematic loan modification program at IndyMac Federal Bank to reduce first lien mortgage payments to as low as 31% of monthly income. Modifications are based on interest rate reductions, extension of term, and principal forbearance. A loss share guarantee on redefaults of modified mortgages can provide the necessary incentive to modify mortgages on a sufficient scale, while leveraging available government funds to affect more mortgages than outright purchases or specific incentives for every modification. The FDIC would be prepared to serve as contractor for Treasury and already has extensive experience in the IndyMac modification process.

To review, loan modifications is the process in which banks restructure loans for borrowers struggling to make the payment on the current loan in order to avoid foreclosure. In other words, if a borrower is having trouble paying a loan at 8%, the bank will drop that rate to 6% or lower in order to make the payment more affordable. Banks will also turn 30 year loans into 40 year loans in order to make the payment more affordable. Sometimes banks will even lower the balance on a loan in order to make it more affordable.

In my opinion mass loan modifications are both controversial and a bad idea for one very simple reason, moral hazard. A loan modification rewards irresponsible behavior. These borrowers can't afford their current mortgage and so the bank fits them with a brand new one they can. If irresponsible behavior is bailed out with a better deal, then it only encourages more irresponsible behavior.

As I have mentioned a couple times, the one loan modification that I saw had these terms. The first five years the interest rate would be 4%. The next two it would be 6%. The remaining 23 years it would be 6.75%. That is an awfully good deal for someone that only got it because they couldn't afford their original deal. Loan modifications are based on ability to pay, and as such, those with great ability to pay their current mortgage, borrowers with good credit, wouldn't qualify for a loan modification.

Yesterday, I wrote this piece about loan modifications. There were those that defended the process and the defense typically said that this was between the bank and the borrower, the two parties to the contract. Here is an example.

Life isn't fair. There's no point in deluding yourself into thinking it is and being jealous that you neighbor got cake and you didn't.

That said, the idea from a bank's perspective is that they aren't getting the money they should, but they need to do their best to maximize what they do get. Forclosure is expensive and, for a bank, a guaranteed loss, and often a substantial one. Rewriting / refinancing a loan is merely a way to maximize the bank's return.

The ideal case for a bank would be to extend the term of the loan and keep everything the same. This would increase the profit over the life of the loan while reducing the monthly payment of the loan holder. This is the simplest approach, but some are going to balk because the amount you end up paying is so much more. However, those same people can sell later or refinance, so I don't see how they could complain.

The next best option is to lower the interest rate. This only has a marginal effect on the monthly payment, and directly decreases profits, but it does mean that the loan will mature on schedule and will reduce the paperwork involved in reforecasting for the bank. This is still cutting people a break, but not so much a handout as...

Reducing the principle on the loan. That's simply handing out cash to people. Not only that, but the forgiven principle is both an immediate write-down for the bank, and it is income to the borrower (who'd then have to pay tax on that income). This is the worst possible solution for everyone. A loss for the bank, a huge tax wallop for the borrower (who's presumably already fallen on hard times), and a slap in the face for those that don't get anything.

The simplest solution: offer a 1-time deal to *everyone* to refinance their current mortgage at 5.5%-6% with a term equal to the lesser of 40 years or whatever term would be satisfied with a monthly payment equal to 1/3rd the resident's after-tax income (based on the last 12 months of income). Banks should fair alright in that deal, lots of people would see their monthly payments drop substantially, etc.

This justification no longer holds water with this news. It appears that loan modifications aren't happening as rapidly as the FDIC would like and so they will encourage even more of it by covering part of the losses should they happen. The FDIC didn't bother to analyze why, in this environment of massive foreclosures, that loan modifications aren't yet more popular. Rather they attempted to force them to be more popular.

My guess is that the banks themselves realize all too well that loan modifications do create a moral hazard. As such, they are likely reluctant to approve too many of them. That's because the bank knows that the end result of the moral hazard they create is a borrower that goes bad on their modified loan. So far, more times than not, faced with the choice of loan modifications or foreclosures, banks are choosing foreclosures. Now, the FDIC will make things much easier for the banks by guaranteeing any such losses.

As such, we have an irresponsible bank once again getting together with an irresponsible borrower to create a new irresponsible loan, and now an irresponsible government agency will guarantee that neither party is hurt when it all goes bad. Talk about a recipe for disaster.


Anonymous said...

Typical liberal ideology. Legislate a shift in supply/demand curves away from some natural equilibrium [in this case an already compromised equilibrium where incentives where in place for banks to make loans that would never have been made without those incentives] in order to remedy some perceived imperfection. Unfortunately, legislating shifts in supply/demand curves away from equilibrium is seldom optimal in the "Pareto" sense - some are better off but some are also worse off.


Anonymous said...

Mr. Volpe,
The last paragraph of your piece cuts to the chase. I recommend that it be borrowed by the MSM, to explain (in plain and simple terms) what the FDIC announcement really means for America in general and mortgage borrowers specifically. But then, that would deny them the fun of being able to creatively interpret the announcement by putting their own partisan "spin" on it, wouldn't it? Imagine them being denied that. Good piece, BTW.