Mortgage Modifications: Help or Hindrance?

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Is the mortgage modification program making things worse?  An article in the New York Times gives voice to fears that by encouraging homeowners to stay in homes that they cannot really afford, Obama's Making Home Affordable program is actually increasing the agony of homeowners, who pour money down the rat hole of their mortgage rather than recognizing the loss and starting over.  In the meantime, the modification programs disguise the true condition of bank balance sheets (because modified mortgages are not yet non-performing mortgages), and slow down the process of recovery.

How much truth is there to this story?  Some, at least.  I found myself talking to my father about this after I exchanged blog posts over the tragic case of Tom Vellucci, a Floral Park resident who lost his job and wound up with a non-paying tenant, then drained his savings trying to keep up with a modification that got him current, but didn't lower his payment.  We're both longtime New Yorkers, so there's a certain local interest in what happened.  We were mystified by why anyone would think that Mr. Vellucci would qualify for a modification--and more importantly, why Mr. Vellucci would have thought so.

Reading between the lines in his story, Mr. Vellucci had virtually no savings (making his house payments tapped him out in four months).  His income was moderate at the best of times, and his house payment was so large that everything had to go right for him.  If he was out of work or lost a tenant for any length of time, he was going to end up in defaulting.  As of the story's publication, he was still on the dialysis that cost him his job, meaning he is not going to regain his income any time soon.  There was no way that any imaginable mortgage modification was going to clean up this mess.  Yet he gave the last of his savings to a skeezy servicer in some sort of tragic Hail Mary pass.

Why would he do something so patently insane?  Apparently he was hoping that he could get a second modification under MHA.  But his interest rate wasn't his problem.  He had a mortgage principal that probably ran into the mid six-figures, and no job, and probably required a modification that slashed his payment in half.  The Obama program clearly raised ridiculous, unrealistic hopes in at least a few people.

That said, the people pushing the notion that MHA is making everything worse have their own vested interests: people who want to pin political blame on Barack Obama; hedge fund managers and other financial types who presumably have taken bets that will pay off quicker and easier if foreclosures pick up; people pushing for more aggressive modifications that write down principal as well as interest rates.  With few permanent modifications yet approved, and no data, it's not clear to me that this is a significant problem, rather than an occasional tragedy.

But I think that the so far lackluster results from MHA do point to something important, which is that we don't have the kind of mortgage crisis we thought we had when we passed the modification.  This represents not only a shift in our thinking about how to fix the housing markets, but a major shift in our national narrative about the housing bubble.  Six to nine months ago, the major story we told in connection with the financial crisis was the homeowner suckered--by either fraud or greed--into a teaser loan with an artificially low interest rate that was going to turn disastrous when it reset.

We've seen some of that, to be sure, particularly with the "Option ARM" or "negative amortization" loans on which homeowners weren't even making the full interest payment.  But that hasn't turned out to be our biggest problem, largely because we are in a very low interest rate environment right now, so many people saw their rates reset downward rather than up.  Instead, we are plagued by negative home equity, and unemployment.  We have a modification program designed to avert a threat that never materialized.

Now we have a choice between two more stories.  One presents the negative equity as the major problem.  Negative home equity is a bigger predictor of default than job loss; so, the reasoning goes, we must be seeing something akin to the infamous "jingle mail", in which people hand over their keys rather than keep making payments on a house that isn't appreciating.

Obviously, this happens.  But I doubt it's particularly common.  Most bankruptcy experts believe that while there are a handful of grossly irresponsible jerks who deliberately borrow as much as they can get away with before defaulting, or otherwise abuse the process, the majority of people who default try really really hard to find some way to make their payments.  (Interestingly/oddly, this does not seem to be as true of student loans and utility bills.)

My story is a little more complicated.  People who lose their jobs, but have positive equity, sell the house when money gets tight. (Five years ago, they probably would have refinanced).

People who lose their jobs, but have negative equity, lose the house.  So do people who get divorced and have negative equity, people who are whacked with unexpected medical or legal bills and have negative equity, people who get hit with back taxes and have negative equity, people who develop a gambling problem or a drug habit and have negative equity.  The negative equity is better correlated--but that doesn't mean that people are deciding to walk away from houses just because they're underwater.

My story is kinder to the debtors, but it also makes modifications more problematic.  If the negative equity is the main problem, you can solve the mortgage crisis by switching to modifications with "cramdowns"--i.e., get a judge or a banker to write off the portion of the principal that exceeds what the house is worth.  This has unpleasant side effects--it would probably pretty much instantly return us to the days of 20+% down payments on every house, and likely cause house prices to fall farther.  But it at least has some hope of solving the immediate foreclosure problem.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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