The promised loan modifications have been elusive for most troubled homeowners. The crux of the problem is that banks have little incentive to do these modifications. When they crunch the numbers, most often it is in the banks' best interest to foreclose or do a short-sale, rather than modify the loan.
What many homeowners do not know is that in many states, banks can go after defaulting borrowers for up to six years for any principal that they lose on the loan. So a foreclosure or a short sale is not the end of the borrower's obligation, unless so decreed by a bankruptcy judge or explicitly written into the short-sale or deed-in-lieu-of-foreclosure contract.
Under the current loan modification program, borrowers must make at least three payments under a trial loan modification program before the modification can become permanent. Transition to permanent modification status also requires additional documentation that many find onerous. More than 600,000 borrowers have begun the trial program, but very few of those have received permanent loan modifications to date.
Unfortunately, under the current program, most troubled borrowers don't even qualify to start the trial modification plan.
Details of the new administration plan are still murky, but comments from Assistant Treasury Secretary Michael Barr hint at the possibility of sanctions and penalties for banks that do not start making more loan modifications.
The administration, of course, is missing the point that the banks' primary responsibility is to their shareholders (otherwise the stockholders will sell and take their investment dollars elsewhere) and therefore the banks will not, as a rule, act against their own financial interests. Imposing penalties is clearly one way to make foreclosure less attractive to banks. In a free-market system, however, carrots often work better than sticks. A better approach might be to offer the banks more positive incentives to perform loan modifications.
The most rational approach from a free-market standpoint, though, is to just let it all play out on its own:
- No bailouts of banks -- increase the FDIC insurance levels and let the bad banks fail. There will be plenty of smaller good banks around who will be glad to take their place.
- No bailouts of industry -- again, economic downturns are traditionally the crucible that separates good companies from bad ones. The failure of big firms is the impetus that drives small innovative firms with good management and good ideas to rise up to take their place.
- No bailouts of individuals -- if homeowners made bad decisions, then they should live with those decisions. Bankrupcty is a reasonable option that allows the person to mostly erase their mistakes and start again under a probationary seven-year period. Given the magnitude of the mortgage problem, my guess is that having a bankruptcy on your credit report will not represent nearly the stigma that it has in the past, since so many people will share that particular blemish.
Maybe it's just the cynic in me, but whenever the government rides up on their white horse to save the day, I cringe a little. It just seems that whenever a bureaucracy tries to fix one thing, they break two other things in the process. With the loan modification program, let's hope they get it right.