More From Tom Brown on Why Loan Mods are Such a Bad Idea

From a February article in the WSJ:

The Obama administration is trying to push through a settlement over mortgage-servicing breakdowns that could force America's largest banks to pay for reductions in loan principal worth billions of dollars.

Terms of the administration's proposal include a commitment from mortgage servicers to reduce the loan balances of troubled borrowers who owe more than their homes are worth, people familiar with the matter said. The cost of those writedowns won't be borne by investors who purchased mortgage-backed securities, these people said.

If a unified settlement can be reached, some state attorneys general and federal agencies are pushing for banks to pay more than $20 billion in civil fines or to fund a comparable amount of loan modifications for distressed borrowers, these people said.

Now, here are Tom Brown's thoughts on the Obama Administration's plans:

What oh what is this strange obsession the people in the Obama administration have with loan modifications, and is there a pill someone can give them to cure it? This notion of a “unified settlement” to benefit delinquent mortgage borrowers is a terrible idea. It won’t help borrowers. It won’t help lenders. It won’t help virtually anyone. Here’s why:

· A global loan mod deal would invite moral hazard, on steroids. Only “troubled borrowers” will get relief? Count me in! It’s the easiest thing in the world for a borrower who’s current to render himself delinquent unilaterally, simply by closing his checkbook. His cash flow improves right away, and his default makes him eligible for the principal reductions his less-prudent neighbor is already lined up for. People will unilaterally default in droves and expect to become eligible for the deal, regardless of what anti-moral-hazard safeguards are proposed early on. (They might even be right; these people vote, remember.) Borrowers would be idiots to not default. What do you think that would do to banks’ loan quality?

· A deal would divert bank capital from other, more productive uses. Like, for instance, lending. Only last week, as she delivered the banking industry’s fourth-quarter report card, Sheila Bair said that “we need to see more lending” on the part of the banking industry. Maybe so. But if banks are going to be forced to shell out for civil penalties to pay for real or imagined transgressions, and shell out some more for principal forgiveness they’ll be strong-armed into granting, there’s going to be that much less available for writing loans that actually have a chance of being paid back. That would not, I should add, be auspicious for the outlook for economic growth.

· Loan mods don’t provide real relief for borrowers. The numbers aren’t just bad; they’re awful. One-third of borrowers who qualify for a modification don’t even make it through the three-month trial period. And as Joseph Mason points out in Friday’s Wall Street Journal, half of those who do make it through the trial re-default within six months. What exactly is the point? The vast majority of modified borrowers end up losing their homes anyway.

· This kind of government intervention will make mortgage credit scarcer and more expensive. Now that lenders know that a mortgage is no longer a simple contract between consenting adults—that, instead, the government might come swooping in to alter the deal’s terms to the material advantage of one of the parties—they will factor that knowledge into their pricing of future loans. Believe me, it won’t make ‘em cheaper.

· Loan modifications squeeze more money out of delinquent borrowers for no reason. If a severely delinquent borrower inevitably face foreclosure (and the numbers are emphatic that that’s the case), why string him along for a few extra months? For the borrower, one of the advantages of foreclosure (and, yes, there are a few) is that he gets to live in the property rent-free for several months. This housing recession is so severe that that can add up to a mini-windfall. These days, typical foreclosure doesn’t happen until 18 moths after the loan first becomes delinquent. That’s a lot of rent-free living. Plus, the sooner the foreclosure, the sooner the borrower can move on with his life (by, say, moving to a city with a better employment outlook) without having to sell the damn house first. So for most borrowers, the loan mod process takes a bad situation worse.

The government has been pursuing its loan modification strategy for so long by now that it’s become abundantly clear that massive, government-instigated loan mods are a terrible idea both in theory and in practice. Have these people learned nothing? A global modification deal would be bad for lenders and borrowers, and a threat to economic growth. The sooner this trial balloon gets popped, the better.