Insights & Advice

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Loan Modifications need to be modified

The government’s well- intentioned effort to stave off default for thousands of American homeowners needs a make-over. By any measure the program does not appear to be stemming the rate of foreclosures.

The situation is serious since that rate is accelerating and some forecasts predict a substantial increase (possibly a doubling) from the 2.3 million foreclosures of last year. Exactly how bad it could get will depend on the unemployment numbers, the severity of the recession, the continued banking crisis and whatever stimulus package the Obama administration is able to pass in Congress. But it is clear that so far loan modifications have done little more than postpone the inevitable foreclosure and may actually be exasperating the crisis.

“A loan modification is a permanent change in one or more of the terms of a mortgagor’s loan, allows the loan to be reinstated, and results in payment that the mortgagor can afford,” according to the U.S. Department of Housing’s website.

Sounds simple enough but in practice it isn’t working for several reasons.

Let’s take Jake, my fictional friend, who got in over his head and is now behind on his monthly mortgage payments by $2,000. He applies and is accepted into the loan modification program after several months of phone calls and applications but by now he owes $6,300 in back mortgage payments.

“Okay, says the banker, “we will just add those back payments to the total cost of the mortgage. For the next seven years forget about re-paying any principal on your home. All you have to pay is interest.”

Jake, thinking that this will drop his monthly payments, agrees.

“Great”, Jake says, “but what about my adjustable rate? Right now it’s 6% but set to move up to 9% next year.”

“Don’t worry,” says your kindly banker,” We will keep your interest rate where it is and convert it to a fixed rate for 30 years.”

Jake signs the papers in relief. He has saved his home and hopefully by the time seven years rolls around he will be able to sell the house at a profit and get out from under. What Jake fails to realize (until it is too late) is that 85-90% of a homeowners monthly payments are “interest only” anyway. And since the bank adds the deferred principal payments to the original loan amount, he is more than likely paying a higher monthly amount than he was before. The lender also gets a sweet deal by charging Jake a 6% interest rate when market mortgage rates are below 4.5%. Of course, the bank will argue that Jake wouldn’t qualify for any kind of mortgage given his credit scores so he should be grateful he is “only” being charged 6%.

By the time Jake’s seven years are up he will still owe the entire original mortgage amount plus deferred payments and the late payments he missed plus interest. And he only has 23 years to pay the larger sum back. Not only has principal increased but so has his monthly payments. In the meantime, he is betting that housing prices will surpass the bubble- induced price that he originally paid for the house. By the way, all this assumes Jake still keeps his job in this recession.

There are several variations of this theme that lenders are offering including lowering interest rates for a part of the loan term and then raising them again later. Others may reduce monthly payments by as much as half for a few years and then double them for the rest of the loan.

So far the results are not encouraging. Over half of all loan modification borrowers have failed to maintain their mortgage payments even after the terms of their loans have been changed. Even the government’s Office of Thrift Supervision admitted that loan modifications might not be the best use of the taxpayer’s money.

The main problem, in my opinion, is the refusal of most lenders to reduce the principal amount of the loan.

I can understand their reluctance. Given the precarious condition of the nation’s banking sector (see my column “House of Cards”) any reduction in the principal amount of millions of mortgages outstanding would be a multi-trillion dollar hit. It would sink the sector. So what about a scheme that would have the government buy up the difference between the reduced and original loan?

Think of how you would feel if Jake not only had his monthly payments reduced but also had 30-40% of his home loan forgiven while we the taxpayers footed the bill. I would be first in line to demand the same deal from the government that Jake received and you would too.

So far the only group that is benefiting from loan modifications are mortgage brokers and loan originators that are making good money charging fees for ‘facilitating’ these loans. So many scams are popping up that the FBI felt the need to warn consumers against organizations that are asking up-front fees for loan modifications.

Another worrisome development is the number of toxic mortgages that are held by the nation’s small business owners. The National Association for the Self-Employed (NASE) estimates that 1,279,800 small business owners have missed one to three mortgage payments by mid-November of last year. That was before a wave of resets on their mortgages was about to begin in the fourth quarter of 2008. At the same time the economy has taken a nosedive which has really walloped the small business owner.
It is one thing when you or I lose a home. It impacts our lives certainly but when a small business defaults the fall-out affects its five or ten employees who lose their jobs. And small business is the real engine of growth in our economy. Loan modifications will need to account for this growing problem. If small business is left to fend for itself, the impact may far exceed the sub-prime crisis and provide a tsunami that none of us want to witness.

Posted in A Few Dollars More, Macroeconomics