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Wednesday, November 26, 2008

Why Mass Loan Modifications in this Environment With Unnecessary Government Interference is so Dangerous

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.

To understand just how truly dangerous loan modifications are everyone needs to wrap themselves around this concept. The better one's financial situation is combined with a steady mortgage rate and payment...the less chance someone has for a loan modification. The worse someone's financial situation is combined with a moving interest rate and payment...the better chance someone has for a loan modification. There is one other concept everyone needs to understand...perception is reality. In other words, the key to loan modifications will soon be to present the borrower as someone in hardship whether that perception is real or not. In other words, loan modifications work in reverse of the way in which loan approvals are supposed to work. More than that, the process of loan modification was something that banks kept in their back pockets to use in those extreme cases where fairly good borrowers really had a hardship and the bank thought they would be responsible enough to handle a lower payment.

Now, this process is about to explode. Nearly every single mortgage company is now developing a loan modifications division. Many former loan officers are creating loan modifications businesses. Why not? Loan modifications are perfect for borrowers that have mortgages that are far too expensive for their monthly budgets. They are extremely appropriate if this process has happened or will happen if a loan adjusts to a higher payment. In other words, the overwhelming majority of sub prime loans that put us into this mess will now be perfect candidates for loan modifications. Just how good a deal does the borrower get. One proprietor of a loan modification business told me they average a new interest rate of 5%.

This is combined with another potentially explosive dynamic. This was never meant to be an en masse business and so not only is it totally unregulated but banks have no set rules for it. There are no guidelines for this process. Banks simply look at a person's financial profile and decide what sort of a payment they should get. Finally, federal and state governments are essentially forcing banks to make this process into something of a mass scale. The state of California has outlawed any foreclosure procedure unless a loan modification has been performed. In other words, if you fall behind on your mortgage in the state of California, have no fear because this action will be rewarded with a loan that is affordable. The bank can't foreclose on you. They have to give you a loan modification by law. Only if you fall behind on your modified loan will you be foreclosed on. The FDIC is now insuring millions of these modified loans as well.

Let's look at some places where there will no doubt be abuse. First, there is the option arms. These are gimmick loans in which the first five years the borrower's payments is set artificially low for the first five years and then resets. The loans were never meant to be kept more than five years. The problem is that will falling real estate prices and restricted credit many of these borrowers simply can't get out of these loans. If you have a $300,000 mortgage, you could for the first five years have a payment as low as $1296 (the payment is figured out as though you had a 30 year mortgage at 2.95% and often times the payment is based on an even lower pretend rate). Once that loan adjusts, your payment will be $2120 (this is based on the rate being 7% over the last 25 years). As this example clearly illustrates, anyone in an option arm can scream hardship. There are very few people that could possibly afford to add $1000 to their mortgage. In other words, almost everyone currently in an option arm is eligible for a loan modification. Many of these folks got into an option arm because the artificially low payment was the one they could afford in order to buy the house they wanted. In other words, they aren't going to necessarily afford much more than their current payment. As such, the loan modification would fit them with an interest rate equivalent to their current payment, or in this case 2.95%.

Then, there is the case of self employed borrowers. Self employed borrowers normally have great difficulty being approved for loans because their income is difficult to track and they write off so much that it looks as though they make nothing. For the purposes of loan modifications, this works to their advantage. There used to be a certain genius to punishing self employed borrowers for writing everything off. After all, if you are going to take advantage of the tax implications of write offs, you are then punished by the mortgage implications. The exact opposite works out to be true in loan modifications. The more upside down a business looks the better a chance the owner has to receive a loan modification. This is also open to so much abuse and manipulation. Borrowers can apply for a loan modification immediately after a bad year. It's even possible that some banks will look at year to date earnings. Once borrowers get an idea of how the system works, the shrewd and unscrupulous ones will be able to find all sorts of ways to abuse the system.

Loan modifications are also perfect for commissioned borrowers. If someone's commission has taken a recent hit, that is the perfect set up to cry hardship. Once again a shrewd and unscrupulous borrower may hold off on collecting on commissions in order to make their income appear low while they are applying for a loan modification. They may ask their company not to pay them commission until such a modification process is over. They may simply apply for a loan modification when their business is slow. The potential for abuse is nearly unlimited here as well.

Finally, there is an obscene amount of potential abuse as far as manipulating debt. One thing that was told me in no uncertain terms was that taking on extra debt wouldn't be rewarded. In other words, if a borrower were applying for a loan modification and the bank looked at their credit report and saw a new car payment, that borrower would almost certainly be rejected. There are plenty of other ways to manipulate debt. Perfectly able borrowers can make their situation look dire. What if you had a long standing credit card which you always paid off monthly but it had a massive limit. Let's say you had a credit card with a limit of $15,000. A borrower could take out cash right befor applying for a loan modification. A really good borrower might have several such cards. Will the bank be able to know that this increased balance was recently manipulated? That's a great unknown of loan modifications because the whole process is brand new.

Then, there is the matter of cash and equivalents. Will banks know just how much borrowers have stashed away if they don't reveal it? What if a borrower is upside down on their debts, but they also have a million Dollar pension? Will the bank know? This is another area that can be manipulated if necessary. Accounts can be liquidated and transferred to family and friends prior to applying for a loan modification. Borrowers may start to cash checks at currency exchanges and hoard cash in order to make their situation appear more dire. This is yet another area where a borrower can potentially make a perfectly good situation look dire.

Finally, once this process really takes off banks will have no choice but to standardize this. Most will have guidelines for who qualifies and for what. They simply won't be able to look at these on a case by case basis when there are millions of them. Once professionals understand how the system works, they will no doubt manipulate it. That's exactly what the entire industry did in manipulating mortgages throughout the boom. The same way in which mortgage professionals figured out how to get unqualified borrowers qualified for mortgages they couldn't afford, these same folks will figure out ways to get borrowers qualified for loan modifications they don't need. Since the federal government is now essentially underwriting these loan modifications, banks will be all too willing to oblige in the next great mortgage fraud.

When Alan Greenspan dropped the Fed Funds Rates to below 1%, this created the artificial push that started the speculative market of sub prime mortgages. Now, the Federal government is doing much the same thing by guaranteeing these loans and by forcing banks to do them prior to foreclosing. The very same kind of artificial stimulation that lead to the sub prime crisis is now being created in this largely unregulated and misunderstood area of loan modifications. Furthermore, the very same artificial stimulation is being done to the very same industry with largely the very same players. Most former mortgage brokers are now getting into loan modifications. They will be dealing with the same banks. They will learn to manipulate the system much like they did when sub prime was booming. The elements for a horrible speculative market are largely the same as those created to start the sub prime crisis. The next great mortgage fraud is here.

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