Loan Mod Catastrophe Can Be Avoided

Is the glass half full or half empty?  Or is it the wrong glass?  On October 8, Treasury Secretary Geitner announced that the Administration’s loan modification program was on target to help 500,000 households avoid foreclosure.  On October 9, a Congressional TARP Oversight Panel released a crtical report that predicted the Administration’s program would, “in the best case,” prevent “fewer than half of the predicted foreclosures.” (NY Times 10/10/2009).  Who’s right?

The problem, of course, is that no one really knows.  The program, which requires completion of a three-month “trial” period for a homeowner to qualify for a “permanent” loan modification, is still in the infancy of the implementation period to provide any meaningful statistics.  According to the NY Times article, as of September 1st, only 1.26% of trial modifications had become permanent, and the plan had produced only 1,711 “permanent” loan modifications.   Many of these so-called modifications involve only a short-term reduction in rate with no reduction in principal, and leave the homeowner upside down with no hope of qualifying for a refinance.  With many Option ARM loans due to reset, and thousands of new homeowners who just entered the market to take advantage of the 3.5% FHA down payment and the $8,000 tax credit, the stage is set for a new wave of delinquencies if the job market continues its current trends.

Another problem is the so-called “shadow inventory” - the homes that should be on the market at a trustee or foreclosure sale, but are not.  The evidence is empirical but not necessarily reliable.  Stories abound of homeowners who have not made their mortgage payments for months, but who have yet to receive a Notice of Default fromt their lender.  Perhaps some lenders are waiting to see how their first round of “trial” modifications play out.  In some cases, the sheer volume of applications has overwhelmed the loan servicers, forcing delays stretching into months while the applications are “under review.”

Bruce Norris recently attempted to calculate more precisely the extent of this phenomenon, noting that the number of Trustee Sales had dropped despite the ever-increasing number of delinquencies.  In July, 2009, he reported the number of Trustee Sales in California had dropped to slightly more than 17,000, compared to almost 29,000 in July of 2008.  Based on the number of deficiencies, the number of Trustee Sales should have been almost three times as many - 52,700!  Running the numbers over the past year, comparing delinquencies vs. trustee sales, Bruce Norris calculates that there are approximately 306,329 additional homes that should have gone to trustee sale in California.  If the rumors about delinquent homeowners who haven’t even been added to the list are even partially true, the discrepancy would be even higher.  And if the best the Administration’s Plan can hope to achieve is “less than half” of the predicted foreclosures, the prospects for success are indeed dismal.  Any grade less than 50% would not be considered acceptable under any circumstances.

Rising unemployment, overwhelmed and untrained loan servicing agencies, and a continuing refusal to provide adjustment for actual market value, are all ingredients for failure.  Add a few scoops of Option ARM resets, continuing chaos in the appraisal system, and a whole new crop of FHA-backed minimum-down mortgages to the mix, and you have the classic recipe for a catastrophe.  On the national level, the conflicting statistics only generate fuel for debate over policies and programs.  But at street level, families and neighborhoods continue to suffer from the collapse of a complicated securitized mortgage marketing scheme that should not have been allowed to take over and replace a more fundamental but functioning system.

What most homeowners facing default fail to grasp is that the investors who hold or control their mortgage have absolutely no incentive or interest in “saving” the homeowner from default.  All that matters is the value of the Note, and in any particular situation involving a portfolio consisting of hundreds or thousands of individual Notes, which in turn comprise security for an investment held by shareholders, the decisions whether or not to modify the terms are made — not for the benefit of the individual homeowner — but purely and simply on the basis of the impact on the value of the portfolio overall.  Complicating this process are multiple layers of IRS, SEC and similar regulations and restrictions that limit the extent to which the portfolio managers can make adjustments without putting the shareholders — or themselves — at risk.  As it is, the best a lender can tell a homeowner in distress is that they will do a “charge off,” effectively shifting the financial burden for the loss from the lender to the borrower.  While it sounds like a huge break if the lender “forgives” a $100,000 Note, the lender gets to write off the loss against other gains, while the homeowner faces the prospect of a $40,000 tax bill via a Form 1099.

There are solutions out there.  Modifying the tax codes and restructuring the securitized mortgage market dynamics would take too long and would offer little in the form of timely relief.  I like Bruce Norris’ concept of returning to the days when an investor could buy a property by assuming the existing loan.  It would be a simple transaction, and return control of the housing market to people willing to work to make it succeed, instead of faceless institutional speculators amassing unmanageable volumes of security instruments that bear little relation to the properties they represent.  Investors would be permitted to manage their risk more directly, and more importantly, homeowners would have the opportunity and the incentive to participate in the process for a successful outcome.  It provides the opportunity for a classic “win-win” that would save families, preserve neighborhoods, and restore communities.