Dick Durbin is once again flapping his gums instead of actually addressing problems:

The legislation, introduced today by Senator Jack Reed of Rhode Island, would require lenders to evaluate all borrowers for affordable loan modifications before initiating foreclosure. It would also require banks to offer and approve a loan modification if the restructured mortgage returns more money, the so-called net-present value, to investors than would foreclosure.

The proposal would establish new penalties and would let borrowers overturn foreclosures if lenders fail to comply. It would also place new limits on fees charged in foreclosure.

The reason we have this crap going on is quite simple, and fixing it is also quite simple:

Banks are holding homes back and foreclosing when they should be modifying as a direct consequence of the policies and actions of the government.

As just one example the “loss share” agreement made with the buyers of IndyMac has set up a perverse incentive system where the usual incentives to modify loans have been intentionally and wantonly destroyed.

If you remember this was the deal announced:

As part of the deal, the FDIC entered into a loss-sharing agreement with IMB HoldCo. IndyMac will assume the first 20 percent of losses on a portfolio of “qualifying loans,” after which the FDIC will assume 80 percent on the next 10 percent of losses, and 95 percent on losses thereafter.

Ok, so we have a maximum loss that the investors (which include George Soros and Michael Dell, by the way) can take which is:

20% + 2% (80% of 10%) + 3.5% or about 25% of the total is theirs – but note that “theirs” is all at the top – once you get into the “meat” of the losses only 5% of whatever is left is theirs.

Here’s the problem: As part of the deal they also get to write down the portfolio as of the date of the deal.  They took that, taking roughly a 25% mark against the assets at purchase (in other words, they bought $20.7 billion of assets at a discount of $4.7 billion)

Now here’s the issue – in a deteriorating market the incentive to modify a loan exists only when the loss on a foreclosure will be materially higher than the loss on a modification.

But if someone “else” (like THE TAXPAYER) will eat (almost all, in this case, essentially 95% of) the loss, then your incentives shift – in a big way.

See, if you modify, you stop earning “fees” on the delinquent note.  You can’t charge late fees any more, you can’t charge “special servicing costs” and similar types of things that you can (and do) get to add to a delinquent note that is “headed for foreclosure.”  These are all immediate cash – and they’re all yours, never mind that if just 1 in 10 of these notes “cures” (after you hound the living hell out of them to pay somehow by hook or crook) you win huge since you got to buy at a 25% discount up front!

These “incentives” to NOT modify are usually outweighed by the much higher loss you’d take if you foreclose.


So now the incentives are wildly tilted toward them telling borrowers to go stuff it up their backside, and they are.

These “loss share” deals are a big, big problem.

It gets worse.

Regulators are refusing to force a mark-to-market on this paper.  We continue to see banks fail where the FDIC reports 20, 30, 40, up to nearly 50% losses, with some sector-specific losses of 60%!  Colonial, again, had a 39% realized loss against their balance sheet claimed values when BB&T came in and purchased them.

The argument for permitting cost-basis (or other forms of “mark to mythology”) accounting is that the market price is in fact “not real.” 

That’s a nice fantasy put forward by the banking industry and lobby but we now have nearly 100 bank failures under our belt and in fact the market price seems to be about where these things wind up – putting the lie to any claim that market prices are “too pessimistic.”  Indeed I have yet to find one instance of a failed institution where balance sheet values ended up being too pessimistic once the regulators came in and started selling things off.

Such “extend and pretend” games, in addition to the ridiculously false view this presents of a financial institution’s balance sheet effectively precludes either modification or foreclosure and resale of the property, because either of those events “finalizes” any embedded and hidden loss and thus forces a mark to be taken.  That could be a wee problem if the bank or other institution doesn’t have sufficient capital to absorb these losses, never mind the hit to so-called “earnings” even if they do have the money.

The reason banks are not modifying loans in good faith and are playing these games is because the regulators AND LAWMAKERS are PERMITTING THEM TO LIE and HIDE losses.

Then, in compounding the error they are entering into “loss share” deals where there is NO INCENTIVE to modify because on a strict financial analysis IT IS MORE PROFITABLE TO “PURSUE FORECLOSURE” since the loss differential IS NOT THEIRS while the fees they can earn from NOT modifying ARE!

Finally, adding insult to injury you have the impact on local and state governments – these properties are not paying property taxes either, being in arrears in some cases by as much as two years.  Yes, this will eventually be recovered via tax certificate sales but the state and local governments deserve to get paid NOW – not five years down the road, when the cause of the delay and non-payment is intentional game-playing by regulators and banks.

Folks, this is really simple: If you want to see those modifications that make sense get done, including but not limited to principal forgiveness where it makes sense, and foreclosures to be prosecuted and properties resold at the market, thereby clearing it, you need to do the following:

  • Force recognition of past-due loans on their current recovery value – all of them – as soon as they go past due.
  • Force banks to foreclose on all loans more than 90 days past due in a diligent fashion.  To punish failure to do so provide that a foreclosure not diligently-prosecuted results in a clear deed being conveyed to the homeowner (that is, 100% loss to the bank!)  That will get their attention – FAST.
  • Force banks to sell into the market at absolute auction all property held by them no later than 90 days after foreclosure.  They get 90 days to market privately for a higher price, after which it goes to the courthouse steps.
  • Force ALL off-balance sheet exposures onto the balance sheet immediately, and prohibit as a matter of law the hiding of exposures off balance sheet (such as the infamous Wachoiva CDS)

In short if you want modifications that make sense to happen you have to stop making it profitable for banks to play games with the accounting so that they are forced to recognize losses as they are realized in the market rather than hiding them in the hope that they will magically “self-cure” (when the data says that is a statistical impossibility.)

You must also get rid of the perverse incentives that make it more profitable for the corporate raiders – who have been given a “no lose” proposition in their acquisition prices – to foreclose instead of making sustainable modifications.

As for the States, I have a solution there too – and perhaps that’s where we should focus our ire, since we can’t seem to get anyone’s attention in Washington DC given all the bribed, er, “lobbied” lawmakers

Change state tax certificate laws.  Sell off delinquent taxes in the fall following the delinquency (assuming a spring “due date”) thereby putting the certificate in someone’s hands six months after non-payment and shorten the allowed redemption (“cure”) period to 12 months – after which the certificate holder can pay the delinquent taxes in full and gain a clear title.  This will put an immediate stop to banks refusing to foreclose or dispose of delinquent properties, leaving them vacant (since they will wind up losing them to a tax sale) and it will stop the bleeding at the state revenue level.  As a beneficial side effect it will force a clearing of the market and re-establish occupancy, maintenance and upkeep of these homes.