No Hope For Bad Debtors?

Why nobody's cramming for the great mortgage test

Have the banks bailed out any mortgage deadbeats? When a Wells Fargo Home Mortgage consultant told me last month that the bank had done absolutely no modifications of troubled mortgage loans since receiving its $25 billion from the U.S. Treasury in October, I thought he was crazy. Now I'm not so sure.

More in a moment about why a low rate of mortgage modifications is a piece of good news disguised as an outrage. I must stress at the outset that I do believe Wells Fargo has modified at least three troubled mortgages since October, and not only because the bank's director of investor relations Bob Strickland said Wednesday that "more than 143,000 solutions" were provided to customers through "repayment plans, modifications and other loss mitigation options."

What are those 143,000 solutions, and how many of them are actual changes to loan terms? There is no way to tell from Strickland's explanation:

Through our active communication programs, Wells Fargo home mortgage has reached 94% of its customers who are two or more payments past due.

For every 10 of these customers we have worked with seven on a solution, two declined help and one could not be reached. Of those who received a loan modification, one year later approximately 7 of every 10 were either current or less than 90 days past due.

Since Strickland uses a base unit of 10, we'll assume that Wells Fargo had at least 10 customers who were two or more payments late. Therefore, Wells Fargo worked with at least seven customers in default.

It is unclear from Strickland's narrative how much of that work resulted in actual loan modifications. (There are three generally recognized types of loan modifications: change of interest rate; lengthening of the maturity date; and reduction of principal, or "cramming.") But presumably some number between one and seven of the people Wells Fargo worked with got to an actual modification. To be sporting we'll call that number five.

Of those five, 70 percent are "either current or less than 90 days past due." Please note that "less than 90 days past due" means "in the same situation they were in before the modification." In any event, that means at least three people have actually received loan modifications from Wells Fargo.

This estimate is more generous than the estimate given to me by a consultant in Wells Fargo's Minneapolis Center, who described himself as having 12 years of experience with the nation's second largest bank, and posed to me the rhetorical question and answer: "Sir, do you know how many loans Wells Fargo has modified? None."

I tried to check that claim with a Wells Fargo representative, who said, "I state emphatically that we are indeed modifying loans and providing other workout options to our customers who are facing financial difficulty," and said "the mortgage consultant you apparently talked to would have no access to that type of data." He was unable to provide any actual evidence, however: no ballpark figure, no sample loan modification, not even a statement from a satisfied customer.

In fact, nobody has access to the type of data we'd need either to refute or to confirm any claims about how many loans have been modified—by Wells Fargo or any other bank—since funds from the $350 billion Troubled Asset Relief Program were delivered. The Office of the Controller of Currency (OCC) issues quarterly reports [pdf] on loan modifications, and more recently has been tracking the number of loan workouts that end up back in default. The OCC's next report is due at the end of March, and will cover the fourth quarter of 2008.

In the meantime, Hope Now, a coalition of big lenders, counselors, and community activists, says 122,000 modifications were performed in December, but its figures have the same vagueness—as to what types of modifications they were and how the dollars were rearranged in each case—as the Wells Fargo numbers above.

And lawyers for Countrywide Home Loans have said in court that Countrywide's claims about working out loans were "mere commercial puffery" and "only Countrywide's vague advertisements."

The bottom line is that while Rep. Barney Frank (D-Mass.) and others may be wrong about the wisdom of helping deadbeats stay in their homes, they are right to be outraged at the banks' lousy loan-modification performance. The Emergency Economic Stabilization Act of 2008 did not specify how TARP funds would be spent, but the salesmanship for the bill certainly implied that this money would allow lenders to keep more people in their mortgaged homes. Financial institutions—in advertising, congressional testimony, marketing, and statements like Strickland's above—have been voluble about their efforts to help troubled borrowers.

"In general, the level of modifications has been disappointing," says Paul Leonard, California director for the Center for Responsible Lending. "Here in California, they have been increasing, but not quickly enough to match the growth in defaults and foreclosures. We are deeply disappointed that TARP activities have not focused on foreclosure prevention."

It's an unexamined truism that loan modifications are "win-win" solutions: The lender gets to keep getting paid, albeit on slightly different terms; the borrower gets to keep his or her home. All parties avoid foreclosure, which, we're told, is in nobody's interest.

But the continuing deflation of real estate prices means real money has to be lost by somebody. If the goal is to keep large numbers of people in houses they can't afford, then the only type of loan modification that will really work is the cramdown, in which the outstanding principal is reduced to reflect the current market.

This of course is a form of theft. You borrow a bunch of money from a bank and then you don't have to pay it all back. Banks naturally don't like this option, and even the generous modification guidelines offered by the Federal Housing Authority build in heavy conditions (such as a requirement that the borrower split proceeds from any future sale of the property) to minimize the loss. It's understandable that few if any principal-reduction modifications are being done.

Yet the OCC's finding that nearly 50 percent of modified loans end up back in default demonstrates that distressed borrowers can't be helped merely by fiddling with the interest rate or changing the length of the mortgage. This has been clear for at least the last 18 months. At the bitter end of his presidential campaign, John McCain brought out a plan to have the government directly compensate lenders in exchange for haircutting bad mortgages. The plan went nowhere. Even the Federal Deposit Insurance Corporation's conservatorship of IndyMac aims to get monthly payments into balance with the borrower's income (which is mostly wasted effort, as nearly half of defaults are the result of job losses), not to reduce principal.

So should anybody have expected that TARP funds would encourage banks to reduce principal, or do other forms of loan modifications? Christopher Thornberg, co-founder of Los Angeles-based Beacon Economics, believes that was a pipe dream.

"The purpose of the TARP funds was not to allow banks to do loan modifications," Thornberg says. "They're being used to keep the credit system moving as banks fail. The problem is that you're still looking at $1.5 to $2 trillion in losses on all kinds of loans, not just mortgages. The good news is that TARP funds were not used according to the original plan, which was to buy inflated assets. The Treasury instead is giving this money to certain banks to allow them to continue lending as other banks fail."

Perhaps it's time to state publicly what the market has already decided: Helping out distressed mortgagees is not good business, at least not on any large scale. You don't have to agree in full with the consultant Ramsey Su, who wrote in The Wall Street Journal this weekend that loan modifications are not only dumb but evil and immoral. But one bright spot about the economic slump is that it has yet to produce its Dorothea Lange, that there has been a fairly general lack of sympathy for irresponsible lenders and borrowers who got themselves (and the rest of us) into trouble.

Nor is there any realistic prospect for stemming the macro decline in asset value by potchkying with some loan terms. Using the Federal Reserve's flow-of-funds data, Thornberg estimates the entire U.S. asset base was overvalued by $15 trillion or $16 trillion in 2007. "As of Q3 2008, households are out $6.6 trillion already. So with Q4 being so brutal we may be half way [to the bottom] or more."

That still leaves a lot of room to fall, and little reason to believe the landing will be any softer the more the nation strives to keep bad debtors in their current houses. The good news is that loan modification in its current form doesn't seem to be making much difference one way or another. I don't believe my Wells Fargo consultant was right with his zero-modification claim. But I kind of hope he is.

Contributing Editor Tim Cavanaugh writes from Los Angeles.