Modifying Loans: The Tyranny of Unelected Judges?

In response to the economic crisis, a new idea is being floated, and it's one that has the support of President elect Barack Obama.

President-elect Obama is meeting with economic advisors today, and you have to believe that the housing crisis will be pretty high on the agenda.

What a lot of folks in the mortgage industry, however, are not high on is the proposal to allow bankruptcy judges to modify loans. This proposal was actually ripped out of the Housing and Economic Recovery Act passed over the summer, because it was a deal-breaker for President Bush. But it is is listed as one of the four main tenets of Obama's housing plan.

There is a fundamental problem with this idea and the main reason is that this idea is done of good politics not good policy. There is an instinct for most politicians to attempt to bend over backwards to try and help struggling borrowers keep their homes. No politician will look good sitting idly by while a foreclosures grip the market.

This particular idea would allow bankruptcy judges to modify loans. Loan modification is the process by which the terms of a particular loan are augmented in order make them easier to pay for struggling borrowers. This is something that a lot of banks already do on the down low. In Calfornia, the process of loan modification is required prior to any foreclosure prceedings. Now, it is likely that bankruptcy judge will also be able to modify loans.

The main problem with loan modification is the idea of moral hazard. A moral hazard occurs when irresponsible behavior is rewarded and thus, more irresponsible behavior is encouraged. In this case, a borrower gets behind, in over their head, or for whatever reason has difficulty making a payment. This loan modification will reward said borrower with a new loan which they can afford. The process of loan modification encourages the very irresponsible behavior that leads to the result.

In this case, it is even worse. That's because this loan modification will be part of a bankruptcy. It's likely these very borrowers were rejected for loan modification by the bank prior to the bankruptcy and then the process of bankruptcy would create the loan modification. As such, this proposed law would not only encourage more loan modifications but more bankruptcies as well. If borrowers know that if they were to file for bankruptcy prior to a foreclosure, that this would lead to their loan being modified, what exactly are we encouraging? Borrowers are likely to fall behind rather than struggle to make payments, file for bankruptcy, and then beg for a loan modification.

The problem is perpetuated by the fact that judges, without any financial training, would make financial judgments. In other words, the modifications, loan amount, the interest, etc., would be made by someone with no training to make such a decision. Furthermore, these judges are mostly unelected or they go through mostly rubber stamp elections. As such, we are giving an awful lot of power to someone that really isn't answerable to anyone. These bankruptcy judges already have plenty of power in such a proceeding. Now, we are going to give them the power to change loan terms on mortgages with little check on their decisions. This problem is perpetuated because deciding on terms of a loan modification is extremely sophisticated. How does someone appeal poorly created loan modification terms? What if a borrower owes $250,000 and the judge cuts the balance to $175,000, how does the bank appeal that this is far too great?

The main problem is that this proposed law, among many, believes that it is pantamount that government do everything it can to keep these folks in homes. In fact, most of these folks need to be removed as quickly as possible, rather than carried with loans they would never get in the free market. The only way for real estate to finally stabilize is for inappropriate borrowers to be removed and for the market to be occupied only with well qualified borrowers. This proposal perpetuates the problem.