Loan Modifications: The Next Great Mortgage Fraud Nightmare

Loan modification is the process by which a bank renegotiates the terms of a loan with a borrower that is having difficulty making their current payment. This was always meant to be a limited process decided on a case by case basis. Yet, with the mortgage crisis in full swing, it appears that loan modifications will soon be a part of everyday mortgage business. As such, all the dynamics are in place for loan modifications to be the next mortgage fraud nightmare and here is why. Loan modifications were never intended to be something that was done on anything resembling a mass scale. Yet, with the mortgage crisis in full swing they have a great opportunity to become legitimate option for a lot of people facing foreclosure.

The first problem is that banks are being manipulated into doing many more of them than they want. Banks have so far been hesitent to make loan modifications done on anything near a large scale. The lawmakers and regulators are afraid of mass foreclosures and many of them see mass loan modifications as the only way to stop it. As such, localities, states, and sometimes the Feds are either mandating loan modifications or creating legislation to encourage them. In California, for instance, banks are mandated to do loan modifications prior to even being allowed to foreclose. Now, the FDIC has announced that they will insure as many as two million loan modifications.

This will force and encourage banks to do many more loan modifications than they ever wanted to or meant to and this new reality will have a terrible effect when it is combined with the next problem,. Loan modifications are largely misunderstood and currently totally unregulated. In those two respects, loan modifications share two important characteristic with another niche in finance critical to this crisis, credit default swaps. In fact, if Barack Obama is serious about creating a new regulatory framework, he would want to make loan modifications near the top of his list (somewhere soon after credit default swaps) Of course, that isn't likely to happen since 1) he wants to encourage as many loan modifications as possible 2) he'd have no idea how to regulate them anyway.

I've so far had minimal contact with loan modifications. (something likely to change soon) What I've seen, only gives me more anecdotal evidence that soon enough loan modifications will get out of control. Both of the loans I've been exposed have perfect mortgage history. Neither of which has been approved, however both have a chance of success. One modification has a loan that will soon be open to an explosion of loan modifications and likely its corruption as well, the option arm. This is a gimmick loan that creates an unusually low payment for five years and then adjusts afterward. Once it adjusts there almost always a massive amount of payment shock. It's not a loan someone is supposed to hold past five years. Because of falling property values and the contraction of loan programs, a lot of people are stuck in them. I know of at least one bank that is already seeking out loan modifications on all these loans. It will be possible for all sorts of borrowers to plead future hardship on such a loan and receive a better deal as a result.

The other aspect of loan modifications that's important to understand is that it is tailor made for someone in an adjustable rate mortgage over a fixed rate. It's easier to present current or future hardship when the payment has changed since the loan started. This system will be easy for an unscrupulous person to game. The unscrupulous borrower will be able to manipulate debt in order to get a loan modification they wouldn't normally deserve. The unscrupulous middle man, the system is designed for middle men to negotiate, has all sorts of ways to corrupt the system. First, there is little required disclosure in the industry. Most reputable firms have their own disclosures, but there isn't necessarily anything that someone is supposed to disclose. As such, these folks can charge what they want up front, as part of the closing, and any other way the can figure out. Unscrupulous banks can require all sorts extra onerous penalties, fees, and add ons in order to pay off the modified loans. There is really no limit the corruption.

Furthermore, the perfect storm for endless corruption has been created. The government is demanding and making loan modifications a nearly no loss proposition for banks. There is little oversight or understanding of the field. There is great demand for it and a system not designed for it. This means banks will likely begin creating departments just to handle this as the vehicle begins to explode. There will be all sorts of growing pains for the product. By the end all of these loan modifications will ultimately make things even worse and the mess we will be cleaning will be even worse years later.