Loan Modifications, A Loose, Lose Story With No Winners

Loan Modifications have been touted as the solution to all evils brought about by the latest economic crises and as the worst idea an administration has ever had.

The administration shouts out that the whole point of Loan Modifications is to help the middle class by giving them a break on their underwater mortgages while many commentators claim that it is just one more ploy to funnel money to big bank corporations that have already received billions in bailout money.

How is it that such an apparently simple idea as modifying the interest rates, loan tenure, and if the borrower is really lucky, the loan principal, is received with such opposite feelings?

The reason is that it is a loose, loose program where neither lenders nor borrowers get what they really want. The intention was good when designing the Home Affordable Modification Program (HAMP) but just as the Communist Manifesto sounded great on paper, the reality is that in practice it simply doesn’t work.

As nobody gets what they want everybody suspects it is a ploy to steal their money so nobody makes the effort needed to make it happen. Another way to see it is that the government is not creating the incentives that would make the ploy work.

Borrowers Loose:

The whole Loan Modification Program is based on a three month trial period that must be “passed” before the loan mod is permanent. In order to qualify borrowers must provide proof of income, pay their monthly payments on time every month, after which they must supply more paperwork. This creates a bottleneck where a lot of applications come in, 750,000 seems to be the last count, but only a very few actually make it to permanent loan modification, around 31,000. And of the few that make it even fewer are that much better off. The reason being that when a loan is underwater, or put another way, when a borrower owes more than his house is worth, the only real long term solution is to reduce the principal. If you don’t the borrower still owes more than his house is worth and there is little incentive to pay for an investment that is upside down when the borrower could simply walk away from a sour deal and put his money elsewhere.

Lenders lose:

Many feel that the only winners in the loan modification (a.ka. HAMP) program are corporate banks. One argument explains that the whole program is designed to squeeze three extra months out of underwater borrowers that would otherwise not think about paying another month. Others feel that it is only another way to get money to banks through the incentives the program offers.

The three month trial scam does carry some credibility because it costs the bank little to reduce payments for three months and carry on with foreclosure proceedings. The cost of manning the loan modification and running the paperwork would probably be covered by receiving payments from the three month trial.

However it seems silly to think that the whole program is designed to give bonuses to banks. The government only pays a “bonus” to banks when they complete a permanent loan modification and there has only been 31,000 of them up-to-date. The maximum incentive a bank can receive for a loan modification is around $4,000 over a period of three to four years, which means that in total the government will pay in the next three to four years around $124,000,000. Compare $4,000 with the loss a bank incurs when they reduce the interest rate of a loan which climbs into the tens of thousands plus whatever principal reduction might be involved. Although it is true that foreclosures are also expensive it is not as if the government’s measly incentive is going to make a loan modification a great deal. This is why banks are not in a hurry to carry out loan modifications, in most cases it is bad business, and even when there is a small margin to be made the rate of re-default with modified loans is high and banks might just be kicking the can down the road a few blocks.