Wednesday, January 27, 2010

On the possible reason why mortgage modifications have so far failed, and some modest solutions to improve results

Mike Konkzal writes a post that sheds a bad light on the mortgage banking industry, and gives a good reason why many people are angry and are considering strategic default. He says that many people who have gone to their banks asking for modification end up getting one, but one that makes the debt burden worse for the borrower.

From Analysis of Mortgage Servicing Performance, more than 70% of the modifications resulted in an increase in the loan balance. Not staying the same, and certainly not decreasing, but piling on more principal for the loan. I’ve seen a lot of bad things during this financial crisis, but this is the most disgusting thing I’ve seen so far. At a time when one out of four homeowners are underwater, banks are using a mortgage modification program to pile on more debt on these loans. They do this even when it’s well known the correlation between the level of being underwater and default.

How? From the report: “Servicers routinely capitalize delinquent interest, corporate advances, escrow advances and attorney fees and other foreclosure-related fees and expenses into the loan balance when completing a loan modification.” So fees allow them to make it look like they are doing their clients a favor, while all they are really doing is running them in a big circle.

He points out that it is ironically the people who asked for a modification from their bank, with the intent of enabling themselves to continue their payments instead of letting themselves end up in default, who end up with larger principals.

These are people who, instead of walking away from their responsibilities, are burning time, money and energy to credible signal to the bank: “I’m in over my head with this mortgage but I want to do right by it because it’s an obligation I made to you. Instead of simply walking away or trying to short sell, is there any way we can work this out so I can still pay you whatever I can? I gave you my word and that means something to me.” And the bank uses their signal that they want to do the right thing to fuck these borrowers the hardest, piling on as much debt as possible on these guys as they can get away with.

So the people who really want to meet their obligations are the ones you screw with as much principal as possible, and the ones who threaten to walk away are the ones you have to take seriously.

This is the dark other side of the strategic default issue - bankers who don’t have a clue, or don’t care, what is happening with their borrowers, and what the ramifications of not helping them are. Firstly, banks have always capitalized any penalties, accrued interest, (and sometimes even any modification fees) into the principal outstanding of any loan. This is how it’s always been done, because these are all the real costs involved in the modification. If payments had been missed, there was a cost of money that the bank had incurred, and that had to be earned back somehow.

But this stance can only be the norm when everything else in the economy is humming along as they always have. It is not so this time. This time around, the options they have are: do what you can to ensure the return of your money, or squeeze the borrower hard, so that you earn as much return on your money as you can.

We are obviously past the point of banks earning their originally projected profit from the accounts, and way past the point where banks can assume that they can expect to earn fees for giving borrowers the privilege of modification. This time around, the obvious objective of the banks should be: do what you can to ensure that the principal that was put at risk in the first place is returned as completely as possible.

And this time around, because of the unsustainable housing bubble that they allowed themselves to be instruments of, house prices have gone down, and in many cases, way below the loan value of their borrowers’ mortgage. And because many mortgages were structured so as to increase rates if the borrower doesn’t increase his equity in the house after a specified period, the recent fall in house prices ensured that many borrowers will not meet that equity requirement, and end up with the increased rates.

This leads to a negative feedback loop where the increased rates has led to more defaults, putting more pressure on house prices, thereby putting more borrowers underwater. Admittedly, this is an explosive combination that can only lead to higher risks with regard to the principal that was put at risk by the banks.

Banks have a fiduciary duty, whether to their depositors, who put their money in the bank on good faith, or to investors, who bought asset-backed securities from them, on the belief that the bankers put in the necessary work of validating the creditworthiness on their accounts, and in structuring their accounts in a way that leads to a stable stream of fixed income until the entire principal on each account is paid off.

Because of this fiduciary duty, banks cannot just declare a mass principal forgiveness on all borrowers currently underwater. This mass forgiveness often cannot help due to several reasons, and I can think of 2 now:
1. This will lead to massive losses, not just to the bank itself and/or its funders, but by extension, to its depositors, and/or the market funds that bought mortgage-backed securities from them.
2. Principal forgiveness will lead to massive writedowns which could provide a negative feedback loop into the real estate market anyway, if it happens that any of their affected funders have to unload properties in response to their investment writedowns.

However, the alternative of no action by banks is way much worse. Borrowers who cannot pay anymore will default. Eventually, borrowers who can still afford, but are pissed because banks don’t seem to care, will strategically default. This will lead to way, way more credit writedowns. In this way, bankers will have failed in their duty to their depositors, funders, investors, and equity holders.

By facing up to their choices, banks will have to admit to themselves that losses have to be recognized, and have to be contained, so that they do not lead to bigger losses later on. Extend and pretend is not the best way forward.

There will be losses because there are borrowers who have lost their jobs, and will not be able to pay no matter what. Banks should do the right thing and foreclose now rather than give the borrower any false hope with a modification that he cannot meet. And there will be losses because there are people who have decreased income now than they had previously, and will only be able to pay with principal forgiveness and/or a much longer term. But the losses that will have to be eaten, though they will be large, will not be as monstrous as with the alternative.

There will be banks that will likely fail, and close, when they face up to their options. But what are they hoping for anyway? Better times? If they know now that they are capital-constrained to afford modifications at the rate and extent necessary, they might as well fail now than fail later.

Government needs to do its part to help. Perhaps more tax incentives to banks that have to eat more losses than they have capital for, will make it easier for their funders and owners to bite the bullet and do what is right.

Depositors need to be reassured more that their deposits will be returned as much as possible if and when their bank is one of those who have to bite the bullet and fail. In this case, stronger banks will have to given the incentives to assume the deposits and liabilities of the failing banks. And in the case of the money market accounts that invested heavily in mortgage-backed securities, well, their investors invested in them with open eyes, knowing that they provided higher returns because they are not insured by the government.

These are not easy solutions, and many people will suffer. But again, the alternative is worse. If there are any of you wondering why there are banks that have so far seemed to promise a fair modification, but whose actions show a completely different intent, James Kwak and his commenters are on to the right reason: Banks perhaps have not communicated a clear change of objectives to the people who are supposed to execute their policies.

Therefore, at the modification level, the banks are still pursuing a return on your money policy, rather than a return of your money. If CEOs and/or owners have not had the stomach or courage to communicate this change, despite promises made, then we can coerce them with a slight variation of the best idea I heard today, from Steve Waldman: take away FDIC deposit coverage. We can take this away from banks that do not follow through on the necessary actions.

Americans, take these as modest advise from one of your neighbours up north of the border. We also have an interest in seeing you succeed in your recovery. After all, if you bring your system down, you take us along with you.

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