Bloomberg reports:

Banks will push the Obama administration to expand its mortgage-modification program to allow interest-only periods on reworked loans, seeking to bring more homeowners into the initiative while recognizing concern that it may only postpone defaults, according to JPMorgan Chase & Co.



You might remember interest-only mortgages as one of the classic subprime ploys that blew up in banks' faces. Why are they going back down that road?

Probably for a few reasons. First, banks are having trouble modifying mortgages in such a way that distressed homeowners can actually afford the payments. These borrowers appeared to be able to handle the doomed mortgages initially because their payments were artificially low -- often paying interest only or even less. As I mentioned earlier this month, that's led many banks to begin reducing the mortgage principal, instead of just the interest rate. But such a move recognizes that the home is worth less than it was when the original mortgage was written. Banks don't like that. Instead, interest-only loans would allow them to at least delay that inevitable result until they can better stomach the associated losses.

But the other reason, I suspect, is because banks simply don't want to foreclose on as many houses as they need to. I noted the phenomenon of banks' shadow foreclosure inventory a few weeks back. That's when banks are holding foreclosure back so not to cause a flood of auctions and short sales in the market, depressing real estate prices. In much the same way, even if interest-only mortgages result in re-default in a few years, once borrowers need to start paying principal, banks might prefer that. At least they'll have some cash flow for the time being, and the real estate market won't continue to deteriorate as quickly as it would if more foreclosures had occurred immediately.

In reality, this idea is crazy. Banks essentially seek to prolong the misery. Instead of ripping off the band-aid, they'd be taking it off very slowly, over the course of the next several years. Once these modified mortgages demanded principal as part of the monthly payments, then we would see re-defaults. In the meantime, people would be living in homes they cannot actually afford, rather than allowing the market to find a real bottom.

There is some legitimate debate about whether or not it would be better to allow the housing market to find a bottom now, or if a slow-bleed would be healthier in the long-run. I prefer the first option, however. I find it hard to believe that consumers would be able to have confidence in a mortgage market where foreclosures are elevated for several years into the future. At least if buyers know a true bottom has been hit, they can feel confident in their investment going forward.

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