The Mortgage Version of Duh!!

Anyone who is a veteran of my work should find this as no surprise.

Many borrowers who received help with mortgage modifications earlier this year tended to re-default on their payments, a top U.S. banking regulator said on Monday, citing recent data.

"The results, I confess, were somewhat surprising, and not in a good way," John Dugan, head of the U.S. Office of the Comptroller of the Currency, said in prepared remarks for a U.S. housing forum.

"Put simply, it shows that over half of mortgage modifications seemed not to be working after six months."

The report is stunning even for someone like me who has long been a critic of the process. If the information in this report is accurate, it is not only stunning but it should be a wake up call for policy making. If about half of loan modifications wind up going bust anyway, then government subsidization of this process needs to stop immediately. In fact, the government should look into ways of making the process illegal.

Loan modifications again are...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.

In other words, troubled borrowers have their loans restructured and made into something more affordable. This report clearly states that most of these loans wind up defaulting eventually even after they are modified. In my opinion, the reason for this is simple. Loan modifications have a built in Moral Hazard. Borrowers got themselves into trouble and their irresponsibility was rewarded with a better loan. As such, they learned no lessons from their irresponsibility. As such, you can expect most of them to be just as irresponsible going forward. Most of these borrowers will run out and buy cars, tvs, bed, and other expensive and unaffordable household items, because that's exactly what they did to get into this mess.

The problem is that banks are now being subsidized by the FDIC to do loan modifications. As such, it is entirely possible that millions of struggling borrowers will be fitted with new loan modifications soon, and given the numbers I just reported, that is a recipe for disaster. Yet, with the FDIC insuring such loan modfications, the mass number of re defaults is exactly what banks need no longer worry about. After all, the FDIC is now insuring them in such a case.

If these numbers are accurate, then we are facing a nightmare. It won't be the banks failing if this continues but rather the FDIC itself. It simply won't be able to withstand having to pay out on half the loan modifications it insures. That will cause a bank crisis the likes of which we haven't seen since 1932. If the FDIC fails, it means the Treasury will have to infuse it with cash to keep it operating. Of course, if it insures enough of these loan modfications, that could cost hundreds of trillions of Dollars. The tax payers will be on the hook for subsidizing the failed loans of millions of irresponsible borrowers.

Of course, this is much more than merely a culture war issue. The Treasury will be in a position to have to spend hundreds of billions on a failed endeavor. In other words, the Treasury will borrow and have nothing to show for it. All this will do is subsidize the FDIC, which will subsidize banks, while they foreclose on borrowers they should have foreclosed on months and years ago. If we continue to be in a recession when this materializes, this will add inflationary pressure without adding one iota of stimulant.