Loan Modification Plus

The Obama administration has taken the lead from Bank of America and Citigroup and expanded its loan modification program to include writing down some mortgage balances.

The multifaceted effort will let people who owe more on their mortgages than their properties are worth get new loans backed by the Federal Housing Administration, a government agency that insures home loans against default.

That would be funded by $14 billion from the administration's existing $75 billion foreclosure-prevention program. But it could spark criticism that the government is shouldering too much risk by taking on bad loans made during the housing boom. In addition, their existing mortgage companies will be able to receive incentives to lower their principal balances.

The program also includes assistance to help unemployed homeowners keep paying their mortgages.

Last summer, Deutsche Bank came out with a startling study about so called underwater mortgages.

A report put out by Deutsche Bank is creating all sorts of business buzz. That's because the report predicts that 48% of all mortgages will be "underwater" by the end of the first quarter of 2011. A mortgage that is "underwater" is one where the mortgage is larger than the value of the house. These sorts of mortgages have a significantly higher incident of defaults. Currently, the number of properties that are underwater is estimated to be at 26% by Deutche Bank. That's bad enough but their estimation is just down right scary at 48%. All mortgage types will see increases in "underwater" mortgages and even prime loans will have 41% of their mortgages under water. (currently on 16% of prime loans are underwater)

This phenomenon, where borrowers owe more than the home is worth, became the elephant in the room. None of the programs helped these sorts of borrowers and this particular study showed that a substantial number would soon be underwater.

This became a central problem for all loan modification programs. With nearly fifty percent of all mortgages soon to be underwater, no loan modification program would do much unless there was something in there to help them.

The problem is that in order to help these folks you'd not only need to lower their rates but the amount they owed. Loan modifications are already inherently open to so called moral hazard. That is that they reward bad behavior. If these borrowers' balances are lowered along with their rates that makes that phenomenon even greater.

So, the original loan modification program put out last spring didn't include any mortgage that was underwater. The Deutsche Bank study showed that such a program wouldn't do much. So, the administration has expanded their loan modification program to include some of these.

This is exactly what Wade Rathke has been calling on for months.

But for many the chairs in the church haven’t changed. Bruce Marks of NACA and John Taylor of the National Community Reinvestment Coalition have been long allies, and not surprisingly their position mirrors mine: there have to be write downs. Jack Schakett, formerly of Countrywide and now in about the same job with Bank of America concedes, as he always has, that there is a place for write downs, and believes they should be extended. Wells Fargo, as always, continues to keep its head in the mud and believe that someone else will solve the problem they helped create.

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But, in this world, 7+ million underwater borrowers are crying for a solution, and writing down principle owed still seems like the only horse to ride.

The payment reduction some of these borrowers would receive could be more than fifty percent. Many of them simply over bought. Most would get a deal a borrower that is on time would never get. This dynamic was at the heart of the mortgage class war that I predicted that I believe turned into the Tea Party movement. There's a bigger problem. It's of policy. I've often quoted this Wall Street Journal article.

Is a housing bailout the solution for clogged-up credit markets and a faltering economy? What the Fed has been doing and did again yesterday hasn't really worked, notwithstanding the pops it produces in the stock market every time it shovels liquidity into the system. The Fed's latest move provides financial institutions another $200 billion in direct short-term lending against their unsaleable housing collateral. The Dow Jones jumped 416 points. But it won't restart markets for the underlying collateral.

Where are the speculators, vultures and hedge funds? Where are the big money players willing to buy the exotic but still substantial mortgage-backed securities for which markets have ceased? The Fed's liquidity rush seems only to have convinced them the time is ripe for staying on the sidelines.

To get to a real solution, speculators and investors need to believe that home prices are hitting bottom, that any mortgage debt they might buy today for 80 cents on the dollar today won't be worth 30 cents tomorrow. Then the vultures will pile in: The transfer of wealth from the overleveraged banks and hedge funds to those who kept cash handy will be shocking, ugly and cathartic -- but it will also be relatively quick. Credit markets will begin to function again. The economy will grow.”

Until there is a bottom, there are no "vultures". Without "vultures" there is no recovery. Loan modifications artificially prop up markets. There is no bottom.