Mortgage Modifications Messes Up Market

Back in August, I wrote about a ruling where Countrywide was ordered not to modify certain securitized mortgages eligible under the Treasury's foreclosure prevention program. The court ruled that the program ignored investors' contractual rights. That was a legal issue. But the modification program could have some disastrous consequences from an economic standpoint. Blackrock Chairman Laurence Fink voices this concern in a Bloomberg article today. He worries about how mortgage modification will affect the future of the securitization market for packaged mortgages.

Here's what Fink says, via Bloomberg:

"I am just very worried," Fink said yesterday in an interview in New York. "How do we get a vibrant securitization market back when we are doing these things in the short run that are good for the banking system and good for the homeowner but not as good as it should be?"

At first, these comments might be a little confusing. How can something be good for the banking system but bad for the market? Bailouts come to mind. They create the presence of moral hazard in the market, but banks love them because their survival is ensured. But Fink's statement is even more basic: what's good in the short-term is not always good in the long-term.

In the very short-term, banks and servicers are getting cash payments from Uncle Sam to modify mortgages. They're also likely getting some payments from the underwater borrowers after modification, before they re-default. But if these modifications were naturally profitable for the banks, they would not have needed government coercion to make them happen. Surely, banks are sensible enough to voluntarily do what's in their best interest.

In the long-term, however, the modification program could have terrible repercussions for the securitization market, and consequently banks. If banks and servicers can modify mortgages as they please, then that creates even greater uncertainty for mortgage-backed securities (MBS). As if they didn't have enough perceived risk already! The more uncertainty investors face, the less likely the securitization market is to open back up for these bonds. That would be bad news for consumer credit. This is what Fink fears.

Bloomberg also notes:

Fink said policies introduced this year to reduce foreclosures are flawed because they don't require home-equity loans to be wiped out before the mortgage is modified. Instead, in a break with the intentions of contracts, the second loan's terms may also be revised, spreading the financial loss among lenders, he said.

Currently, banks and servicers modify home equity loans thorough the Obama administration's program as well. These home equity loans have a lower priority than the mortgages. In the case of foreclosure, if there is not enough equity in a home to cover the value of the mortgage, then the lender who provided the home equity loan should face a total loss.

That's not what's happening under the modification program. Instead, both loans are being modified simultaneously. That disregards the first lien nature of the mortgage, which is supposed to have a higher priority than the home equity loan. This means that a part of the home equity lender's loss shifts to the mortgage lender. Again, this turns market expectations on their head and does exactly the opposite of what lenders and investors anticipated.

The modification program makes a mess of the market, because it creates extraordinary uncertainty. Contracts are disregarded; lender priority is meaningless. In order to have a robust securitization market, you need the rules of the game to be very clear-cut. Fink is right to worry that, ultimately, investors are going be very wary about buying mortgage-backed securities, even after the mortgage market regains some normalcy. They may worry that the government could just step in again and nullify the rules governing the MBS they purchased.