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Why Banks Aren't Modifying Enough Mortgages

Apparently Treasury Secretary Tim Geithner and HUD Secretary Shaun Donovan are planning a sit-down with the top 25 mortgage servicers on July 28. The issue is that the banks have been slow to modify mortgages in danger of default and foreclosure, despite the administration's Making Home Affordable plan, which was supposed to give servicers incentives to make those modifications.

The failure of servicers to make modifications in the volumes expected by the administration probably has one of two causes. First, it could be that they don't have the systems and processes in place, although the appropriate response to that excuse is: "Why not?"

Second, and more likely in my opinion, it could be that the incentives just aren't big enough.

This is what I said about the housing plan when it was announced in February:

The main concern is that the plan does not go far enough. This is because the main proposal for struggling homeowners is to provide cash incentives to lenders. It is impossible for the policy wonks in Washington to predict just how many mortgages will be modified with the bonuses offered.

If they are acting rationally (I know, a big if), the lenders have already done a calculation on every delinquent mortgage they hold, and they have already decided not to modify the vast majority of them. So the question is, will a few thousand more dollars ... tip the equation toward modification? And in how many cases?

This administration's approach is always to try to provide economic incentives to get the behavior it wants, and if it isn't happy with the volume of foreclosures, that implies that the incentives aren't big enough. The problem is aggravated by the fact that the lenders who hold these loans (whose interests the servicers are supposed to protect, and who are sometimes identical to the servicers) have distorted incentives.

Instead of maximizing the economic value of the loans they hold, accounting regulations encourage them to maximize their accounting value, which means putting off writedowns for as long as possible. As Joe Nocera put it, "Sure, foreclosure ultimately costs the bank more money than a modification would. But foreclosures these days take a long time — as much as 18 months in some states. And all that time the banks can keep the loans on their books at inflated values."

Not only that, but banks now are hoping that they will never have to take writedowns from those inflated values. They may be hoping that an economic recovery will bail them out of their toxic loans. But more important, the administration's behavior since taking office has sent the signal that the administration truly, deeply, desperately wants the banks to earn their way out of their problems.

This implies that if Citigroup or Bank of America is looking at large writedowns in 2011, the administration will find a way to help it avoid that problem, or to otherwise keep it afloat. If I'm a bank and I think I can count on that kind of assistance should I need it, I'm going to do everything I possibly can to avoid a writedown today -- and that includes dragging my feet on mortgage modifications.

President Obama's economic team is one of the smartest ever assembled, and they have memorized the chapter on using economic incentives to influence behavior. But ironically, their biggest policy bet -- deciding that no large bank or its managers would ever have to face the consequences of their actions -- has itself distorted banks' incentives across the board by encouraging them to depend on the implicit government guarantee. Set against that distortion, a couple thousand dollars for a loan modification doesn't go very far.

By James Kwak  |  July 13, 2009; 11:15 AM ET
Categories:  Banking  
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Thanks for a good post that gives me a new perspective on the failure of services and lenders to modify.

While everyone seems to be focused on the loss of financial wealth - much of which was a fantasy all along, the destruction of wealth when houses lie vacant is truly monumental and destructive. This is an instance where "incentives" is the wrong tool. For the good of America's families, communities, and the entire economy, Obama and his minions should do everything possible to mandate workouts and modifications. That way, in the long run, banks will collect more and fewer houses will lose their value thru prolonged periods of vacancy that lead to looting and other forms of deterioration.

Posted by: charliecoop | July 20, 2009 10:14 AM | Report abuse

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