First and foremost, the study validates the fact that principal balance reductions in mortgage modification were truly an urban legend.

How mortgage modification shops were set up to influence individuals into thinking that they could get massive reductions in principal is beyond me…

However, at least for 2008, the verdict is now in.  Only about 1.3 percent of all mortgage modifications included any principal reduction at all.  Frequently, mortgage modifications have included increases in the outstanding principal balance.  In fact, in the third and fourth quarters of 2008, principal balance increases occurred on 70.9 percent and 61.5 percent of all loans respectively.

What did occur, however, is there were indeed meaningful reductions in the monthly outlay that individuals had on their particular mortgages because of increasing the term of the loans as well as substantially reducing the monthly interest due on the loan.  Thus, the average loan that was modified in the third and fourth quarter of 2008 saw a 21 percent reduction in monthly payments.  In a few cases, however, approximately 6 percent of modifications during that same period actually saw an increase.

Now it is very important to understand that in 2008 President Bush was still in office and President Obama had not yet implemented any of his financial stimulus packages.  Thus, anecdotally, we are now starting to see, on occasion, principal reductions in certain modifications.  Certainly, the number is well in excess of 1 percent, but is not something that is occurring on every loan with any certainty.

Policymakers and individuals frequently do not understand why banks are so reluctant to reduce the principal balance of a loan to the value of the property.  I always thought that the reason was that the banks were concerned about creating a contagion of individuals who possibly could afford to pay their mortgage, but have decided to seek modification because they don’t feel it’s fair that their neighbor is getting a modification while they are not.

In fact, as previously discussed in my prior blog about foreclosures and social networks, researchers have distinguished “strategic foreclosures” to be when an individual walks away from their home because it does not make economic sense to continue making payments when the property is underwater. While the term does not exist in the area of mortgage modification, perhaps banks are concerned about continuing to modify too many loans thereby unwittingly encouraging “strategic modifications.”

In fact, a bank’s decision to not embrace modifications is actually quite simple, yet it lurks beneath the surface…

Loan Modifications and Decreased Values
First and foremost, the reason many banks chose not to embrace modifications was that property values were going to continue to erode and decrease.  Under such circumstances with knowledge that many such modifications would fail, the bank would net even less money than they would if they brought the foreclosure immediately.  Thus, the banks thought they should just get it over with, take the medicine and this would leave them in better shape than if they allowed for a modification that then subsequently failed.  The fact of the matter is that, certainly in the past year, the banks were not wrong in that prices have continued to fall and thus by doing a quick foreclosure they would be in better shape than allowing the property to linger and continue to deteriorate in value.

Loan Modifications and “Self-Curing”
The second reason that the banks were reluctant to conduct modifications is because they felt that they would be shooting themselves in the foot.  Specifically, the banks know that a fairly decent percentage, as much as 30 percent of all loans that are in default, will “self-cure” and bring themselves back into compliance— meaning that they will no longer be in default.  Obviously, if the banks decided to modify an entire portfolio of mortgages they would lose the opportunity to receive the additional income from those mortgages or individuals that decided to self cure their default.  When the bank factors in the loss of “self-curing” mortgages their loss is much higher than when they decide to only modify certain loans and then anticipate that other loans may indeed “self cure.”

The problem with the self-cure analysis is that it is based on an economic environment where equity in homes historically had not fallen more than 20 percent below the mortgage amount.  As discussed previously we are now in an environment’ where many homes are as much as 50 percent underwater and the idea of self-cure is highly unlikely.

The Feds paper concludes, that “if the presence of ‘self-cure’ risk and re-default risk do make renegotiation less appealing to investors, the number of easily ‘preventable’ foreclosures may be far smaller than many commentators believe.”

Thus, it is still my contention that if the government wants to deal with the foreclosure crisis and make sure that it does not continue to get worse and become a contagion, that the focus must be on restoring an orderly pricing structure to the market by providing the proper incentives to individuals and investors to come back into the market and re-stabilize the housing market.  Like any market, if there are too few buyers and too many sellers, prices will continue to decrease.  If we are able to bring more buyers back into the market prices will stabilize, the number of defaults will decrease, people will be more reluctant to walk away from their homes, the number of foreclosures will no longer increase, and what economists call a “negative feedback loop” will finally be stopped in its tracks. And guess what? The banks will no longer be afraid to modify loans.

For more information view my video interview about banks and mortgage modifications.

Roy Oppenheim

Some have suggested that Wall Street’s exportation of toxic mortgage-backed securities to investors throughout the world was “evil genius” if in fact it was a plan to create the equivalent of a Trojan horse by destroying the rest of the world’s economy. Of course, the problem with that theory is that we took our own economy down in the process. In order to undo the damage and pain that we have inflicted, America needs to unwind or rewind the process. It is hard to envision how to do that unless we dust off our history books and look at what FDR did in a similar situation.

During the depression housing prices had dropped 30 percent.  50 percent of all homeowners were in default and a vast majority of homes were underwater, meaning that there was no equity or negative equity in such homes. This situation is similar to ours now, where rational homeowners have no incentive to keep paying their mortgages. In fact, right now in Florida, a whopping 20 percent of all mortgages are at least 30 days behind, which means that the foreclosure rate will likely double.  Our government has to realize that eventually, a tipping point will occur.  Even the homeowners, who may be under water but are still paying their mortgages, have to ask why they are the only chumps on the block still paying.  When we get to that point in our social and economic fabric it may get so torn that it will be difficult for us to re-stitch it.

So what is the answer?

First and foremost, the government has to get over the whole moral hazard issue. The idea that the government can’t reward bad behavior is now a hollow argument when AIG, and GM did so many things wrong, yet have received tens of billions of dollars in bailout funds and will likely not fully survive. It is fair to say that AIG and its counter parts in default swaps took huge risks and should have been big boys and been responsible for their decisions. Yet, the Federal Reserve decided that the havoc and chaos that would ensue by allowing these titans to fall was a price that, as a society, we could not endure.

The same holds true for the average Joe and our housing market.  Lets face it; the real estate industrial complex represents 25 percent of the entire GNP.  Thus, if people feel no obligation to continue to pay their mortgages forget about AIG, we all have a much bigger problem than worrying about AIG’s obligations to Goldman Sachs and Bank of America – who, might I add, received billions back from AIG thanks to Uncle Sam!

Thus, the answer is so simple and may not even cost the government more than $200 billion over 18 years.  The US government needs to bring back a new version of the Home Owners Loan Corporation (HOLC) that could effectively issue non-recourse loans to homeowners.  These loans are equal to the difference between a homeowner’s outstanding mortgage principal balance and the market value of the home. The proceeds of these loans will go to the banks and be applied to pay down the excess mortgages – thus immediately reducing the monthly payments that each homeowner owes the banks.

However, more importantly, the plan would allow the toxicity of the mortgage-backed securities to quickly disappear almost like a strong dose of an antibiotic to a raging bacterial infection. If the mortgage-backed securities became well again, liquidity would quickly return to the markets, and the banks balance sheets would rapidly improve the stock market – and, most importantly, people’s pensions would not be at risk.

The HOLC was formed in 1933. By the time it wound down, it had only foreclosed on 20 percent of its mortgages and ended up effectively breaking even. Assuming that the cost to the government would be an initial outlay of $200 to 300 billion overtime, the government could realistically expect to see back 80 percent of its investment or a relative small “loss” of $60 billion over seven years.

The key to implementation is simplicity so that everyone understands how we all benefit. Plain and simple, if the swimming pool is drained all boats will float. No more complex administrative policy discussion, what America needs is a simple focused philosophy. If Main Street benefits so does the stock market, and our pensions, and our European friends to whom we sold  “infected” securities. In fact, unwinding this mess is simple, start at the bottom and work your way up the ladder. Not the other way around. And guess what, a bailout that trickles up is sure better than a bailout that does not trickle down.