Mods For All

The leaked settlement term sheet between the state AGs and certain banks concerning their proposal for settling various issues relating to faulty foreclosure practices is, sigh, once again giving life to the modification crowd.

Felix Salmon uses BofA’s announcement that it’s going to segregate some of its mortgages in a “bad bank” as a jumping off point for his harangue. Before we get to the modification issue, let’s take a brief detour and examine his beef with the use of a vehicle for bad legacy loans. He says of the decision:

Essentially BofA is doing two things here. One is to try to sweep its bad loans under the carpet by creating the new Legacy Asset Servicing unit; the other is to step up its pushback against the proposed mortgage-servicingsettlement, which quite explicitly does include loan modifications for borrowers who aren’t in default. Check out part II.K.8:

Well, if by moving a sizable slug of bad assets off of its balance sheet and, by the way, taking an equally sizable hit to earnings for such a move amounts to sweeping things under the rug in his mind then so be it. The facts are that segregating asset classes that are considered to be of questionable value has been for a long time a fairly routine way of dealing with the issue. It’s also known as biting the bullet, you take your loss and move on. Felix fails to note that the Bloomberg article he links to points out that JP Morgan and Wells Fargo have done the same thing.

Somehow, as you can see from the second part of his statement, putting loans into a bad bank is a devious way to abet its resistance to the AG settlement proposal. I fail to see the logic, but more to the point, Felix appears to now be espousing modifications for all. He then disingenuously adds:

This is something BofA hates — because it opens the door to underwater borrowers who are making timely payments being able to get a loan modification and thereby reduce the value of the loan. And BofA CEO Brian Moynihan is on the warpath against it, saying that such a system would be unfair to borrowers who don’t get their loans modified.

As Adam Levitin points out, Moynihan’s line of argument is pretty disingenuous. There’s nothing in the proposed settlement which forces BofA or anybody else to do anything unfair: indeed, BofA is encouraged to draw up its own set of standards and then apply them to all of its borrowers in a consistent manner. The real reason that BofA is fighting back is simple: if it behaved according to the settlement’s guidelines, it would lose some of that $35 billion to $40 billion a year that Moynihan reckons it should be able to make going forwards.

Just that simple folks. You can’t discriminate among borrowers who are in default or not in default. If you modify for a deadbeat, you modify for someone who is current. I assume from his words that he believes this is doable economically for BofA and the rest of their cohorts, since his implication is that it would only cost them a piece of their yearly earnings.

The likely reason that Felix and the mods for all crowd have abandoned modifications only for those in default is probably because they couldn’t glide around the issue of picking winners on the basis of loan default. Indeed, Felix alludes to the problem and suggests that it is solved by gifting equity to all underwater.

Into this fray come some economists from the Atlanta Fed. In a paper titled, “The seductive but flawed logic of principal reduction”, they argue that the research shows that most borrowers with negative equity will eventually pay off their mortgages. Why this should be so is perhaps somewhat of a conundrum since logic might dictate default but we are dealing with human beings here. The authors point out that a belief that home prices will recover, a desire not to destroy their credit, attachment to the home and other considerations probably weigh on the decision to remain current. I would add that some believe in the concept of forced savings and are more concerned with eventually owning shelter free of liens than they are with the current investment value of the property.

But let’s get back to the math. After all, that is what is going to drive any settlement. The Atlanta Fed economists have this to say about mods for all:

With this idea in mind, it then follows that if we could somehow get everyone back into positive-equity territory, then we could end the foreclosure crisis. To do that, we either need to inflate house prices, which is difficult to do and probably a bad idea anyway, or reduce the principal mortgage balances for negative-equity borrowers. So we have a cure for the foreclosure crisis: if we can get lenders to write down principal to give all Americans positive equity in their homes, the housing crisis would be over. Of course, the question becomes, who will pay? Estimates suggest that borrowers with negative equity owe almost a trillion dollars more than their homes are worth, and a trillion dollars, even now, is real money. The principal reduction idea might stop here—an effective but unaffordable plan—but people then realized that counting all the balance reduction as a cost was wrong. Furthermore, in fact, not only was the cost far less than a trillion dollars, but, as we noted above, many principal reduction proponents argue that it might not cost anything at all.

Now a trillion dollars is real money. We are beyond the realm of suggesting that the banks can pay out that sort of scratch from earnings. Only the feds have those sorts of resources and as we all know that bucket is pretty empty these days.

As for the argument the authors cite that loan modifications for all wouldn’t really cost that sort of money, well it’s based on the assumption that all of those underwater would default and the banks would lose an equivalent amount foreclosing. They nicely debunk this argument in their paper. They also rightly point out that the $20 billion price tag being bandied about in the settlement is woefully insufficient to even address the issue of those underwater and in default. In other words, $20 billion is only going to allow the banks or the government or whoever oversees this giveaway to pick winners.

Clearly, there is no way that all of those who owe more than their house is worth are going to get bailed out. In a perfect world with unlimited resources we could afford to gift equity to all of the buyers who mistakenly believed owning a house and borrowing money was a riskless proposition. We don’t live in that world. Felix and his fellow travelers can continue to lobby for the impossible, but the reality is that most of those underwater homeowners are going to tough it out and pay off their loans. A few are going to win the lottery and be made whole and a lot are going to lose their house to foreclosure.

I’m tired of saying it but the sooner we quit whining about the absence of miracles on this worldly planet and deal with this problem in a manner consistent with available resources, the sooner we can get back to some semblance of a functioning residential real estate market and move on.

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