The most common objection to some of my doom and gloom predictions to the process of loan modifications come from those that point out that banks have so far been reluctant to do many loan modifications. There needs to be some perspective on this. It's true that banks haven't done all that many loan modifications at least compared to how many applications there have been. That said, prior to six months ago or so, banks would do a handful of loan modifications yearly. Now, in the last six months, they have received millions of requests for loan modifications. While they have denied most requests, there is no doubt that banks have approved exponentially greater loan modifications in the last half year than they had at any time prior.
Banks have been reluctant, in my opinion, because at their core they understand how ludicrous loan modifications are. Again, loan modifications occur when a borrower is struggling to make their mortgage payment and the bank re negotiates them into a loan that is more affordable. In other words, if you have a loan you can't afford, not to worry, because a loan modification will save you.
Now, while banks are reluctant to do too many loan modifications, the government is amped up. That's because the government, at most levels, is determined to stop the rising tide of foreclosures at any cost. Loan modifications offer one of the best options to any politician that has a myopic belief that foreclosures must be stopped at all costs. That's because, they offer an easy alternative that is already available. Other options would include drafting new legislation. It would mean creating new government bureaucracy, and it would mean that government would need to manage it all. Now, ironically enough, politicians will likely find that making loan modifications play a significant role in confronting foreclosures.
Still, I believe that Obama and the Democratic legislature will draft all sorts of legislation that will either encourage banks to do more loan modifications or even force them to do more. I see two potential pieces of legislation that will create nightmare scenarios.
First, Obama could nationalize what they did in California. In California, a borrower can't be foreclosed on until they receive a loan modification. Only if that same borrower goes bad on the new modified loan can they then be foreclosed on. This would create a nightmare that is simply unquantifiable. If someone falls behind on their loan, they know they can't be foreclosed on. They know that such a position immediately entitles them to get a better deal. This creates all sorts of incentive for those on time to fall behind and those behind to simply stop paying. It encourages the worst kind of behavior in borrowers. If this were implemented, we would likely see all sorts of folks fall behind or fall further behind in order to get a better deal. Besides maintaining good credit, borrowers would have no motivation whatsoever to stay current on their mortgages. As such, any borrower who's credit is already in jeopardy would have little if any motivation to stay on time. Keep in mind, in this scenario, falling behind on your mortgage means you are ENTITLED to a new mortgage with better terms.
The second option is actually a lot more likely. Last week, I wrote about a proposal that will get a hearing in front of Congress. Obama might try and use the TARP money or other bailout money to do something similar to the proposal. In the proposal, the federal government would seize bad debt, renegotiate it themselves, and package it themselves and sell them as bonds. This is likely far too heavy handed to pass Constitutional mustard. As such, Obama might instead set aside tens of billions in either TARP or stimulus money to do something similar. Rather than forcing banks to give up bad debt, he would encourage banks to give up the debt by offering them a way to remove it from their books. The plan would work something like this. If banks did a loan modification for a troubled borrower, the federal government would then immediately buy that new loan from the bank at an amount that would be worthwhile to the bank. Such a deal would allow banks to instantaneously remove their "toxic debt", and it would allow Obama to stop foreclosures cold.
Banks are reluctant to hold onto loan modifications because they know that in general a bunch of modified loans are even worse than just foreclosing. Now, if Obama were to offer banks a way to modify and remove that paper, then that would remove all qualms banks have in doing them. That would set off a frenzy of modifications because the money would obviously not be endless. Furthermore, all rules would go away. Banks have almost no care about who gets modified. All they are trying to do is remove bad assets from their books. If someone is behind on their mortgage, then they could be removed through this modification. Since only mortgages that are behind would be considered, it would also instantaneously encourage every borrower to fall behind on their mortgage. How many would fall behind is any one's guess? I would suspect that just as many people would fall behind in order to qualify as would be saved from foreclosure through this process.
Then, Obama would have to decide what to do with all of these loans. The government could decide to become the bank for all of these loans similar to FDR's Homeowner's Loan Corporation. Of course, such a move would require creating another massive government bureaucracy. Thousands of people would be required to organize and administrate these loans. All of the functions of a bank would have to be done and on a very mass scale. The other option that Obama would have is to package these loans together and sell them off as bonds. This would prove even more tricky. It would require an even larger bureaucracy. Not only would all requirements of a bank be necessary but all requirements of a loan securitizer be necessary. Such a department would rival the biggest in our bureaucracy. It would also be next to impossible to price. These people would receive rates they didn't deserve. As such, the pricing model doesn't exist.
In either scenario, there is a real possibility that millions of homeowners would be motivated to fall behind on their mortgage specifically because that's how they qualify for this process. Both scenarios would ensure that loan modifications would become industry standards. Both scenarios ensure that loan modifications would be done on a mass scale with almost no oversight. Both would create the sort of nightmare I have been writing about regarding loan modifications. Watch how the Obama administration treats this tool to see just how bad things will get.
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