Bankers: Obama loan modification plan will require another bailout

Facing rising discontent over a flood of coming foreclosures, the Obama administration wants to push harder to get lenders to modify underwater mortgages.  ABC News reported yesterday that Barack Obama’s policies up to now haven’t solved the problem, according to a new report from the Congressional Oversight Panel.  Less than 20% of the applicants for principal adjustment have received approval:

President Obama’s plan to help the 11 million Americans whose homes are underwater isn’t working, according to a new report that will be released tomorrow on Capitol Hill by the Congressional Oversight Panel. The plan called for banks to adjust mortgages for homeowners paying more for their homes than they’re worth, but most aren’t receiving the help they requested. Legislators are already demanding that the big banks to do more, but today, four of the nation’s largest banks pushed back. …

Of the more than 1.1 million homeowners who signed up for mortgage help through the president’s adjustment plan, only 170,000 have had their mortgages permanently adjusted. Experts say that’s a dismal performance.

One of the people reported to be on Obama’s short list for the Supreme Court opening offered her perspective on the reluctance of banks to write down more of the loans:

“We might not be able to help everyone, but taxpayers bailed out the banks and banks could be doing much more to adjust mortgages,” said Elizabeth Warren, a Harvard professor who heads up Congress’s Troubled Asset Relief Program oversight panel.

The problem with that approach is that it will require even more bailouts of banks and lenders, as the Washington Post explains today:

Reducing a borrower’s principal balance is appropriate in limited circumstances and will probably be done more over the next year, executives from Bank of America, Citigroup, Wells Fargo and J.P. Morgan Chase told the House Financial Services Committee. But widespread use of that type of relief would raise questions of fairness and could encourage borrowers who are not in distress to default, they said.

“Principal forgiveness is not an across-the-board solution,” said Michael Heid, co-president of Wells Fargo Home Mortgage. It “needs to be used in a very careful manner.”

More than 11 million homeowners owe more than their properties are worth, a situation known as being underwater, according to data from First American CoreLogic. These homeowners are considered at higher risk of foreclosure because they can’t sell their homes or refinance their mortgages in the event of a financial setback, such as a job loss.

But cutting underwater mortgages to the value of the homes would cost the industry and taxpayers $700 billion to $900 billion, David Lowman, chief executive of J.P. Morgan Chase Home Lending, told the committee. That would include $150 billion in losses for government-controlled Fannie Mae and Freddie Mac, as well as the Federal Housing Administration, he said.

Once again, we’re heading toward a solution where taxpayers who invested wisely in their homes will have to part with their money to subsidize the bad decisions of other homeowners.  Regardless of whatever else that solution does, it penalizes careful management at the same time it subsidizes folly.  It presents a large moral hazard that will produce a lot more of the latter than the former.  What incentives do people have in being careful with their money if the government bails them out repeatedly when they make bad decisions?  Why shouldn’t everyone take unnecessary risks under those circumstances?

Lenders already do write-downs on their own when the circumstances make good business sense.  As has been repeatedly explained, lenders have a serious financial interest in maintaining the viability of their debtors, because foreclosures are usually a disaster for both.  That kind of decision doesn’t require taxpayer subsidies, and those that do require those subsidies have a much higher risk of failing anyway.

The best way to protect against massive foreclosures on underwater mortgages is to restart the engine of job creation.  Unemployment is the biggest risk factor for these loans; as long as buyers can make the payments, it doesn’t matter whether the principal is greater than the value of the house at the moment.  These bailouts send exactly the wrong kind of pricing signals to investors and will further burden the expansion of the economy that’s required to actually solve this problem.  We don’t need more government intervention — we need government to get the hell out of the way.