Tom Lawler, founder of Economic & Housing Consulting, and a former director and senior vice president at Fannie Mae, provides Answers to Your Questions on the Foreclosure Crisis.

I pickled that link up from Calculated Risk who highlighted one question. Here is a different question I want to discuss in more depth.

Q: Why does it make more sense for a bank to foreclose rather than writing down the loan to keep people in their homes? I know many folks who can qualify, based upon current income and credit, for loans based upon the homes’ current market values. (Most homes are down 50% here from 2004-7.) However, the bank would rather foreclose than renegotiate with the current owner. Many of these folks are current on taxes, HOA, etc. Is it an issue of spite to discourage strategic defaults?

A: This is a loaded question. While many lenders/servicers have not done a great job in dealing effectively with borrowers who are struggling to make mortgage payments, by the same token many borrowers whose home values have plunged and have made no payment for well over a year want the banks to write down their mortgage balance to today’s distressed-value levels, so that if home prices later go up, they can reap any future appreciation even if their home value remains below their old mortgage balance.

Banks and lenders, not surprisingly, are not crazy about doing that! Instead, most offered modifications that are intended to reduce a borrower’s payment, but not in any meaningful way reduce the borrower’s mortgage balance.

So let me state it differently: Suppose you had lent money for someone to buy a home for, say, $300,000 with a – crazy as it sounds – $300,000 mortgage. Property values then fall, and that person just stopped making any payments, and said that he/she wanted you to write down the mortgage balance to, say, $150,000, because that’s what the home is worth today.

You counter with an offer to temporarily reduce the borrower’s interest rate to, say, 3 percent from 6 percent. But the borrower says, “Fuggedaboutit, I want my mortgage written down to $150,000, so if home prices rise again, I’ll make money!” How would you react?

The question says that a bank “would rather foreclose than renegotiate.” But what is the right renegotiation?

The Seen and Unseen

Lawler answered the question with two questions, but there is another factor at play that is far more important. I am surprised he did not mention it.

Here’s the real deal: If lenders gave loan modifications to everyone who was seriously underwater, it would openly invite everyone who was underwater to stop paying their mortgages.

Thus, while it may appear to make economic sense to work out a principal reduction (the easily seen effect suggests the lender would lose less by working out an arrangement than opting for foreclosure then having to unload it at fire sale prices), it is highly likely to be a losing strategy in the long run because it creates a moral hazard of opening inviting everyone who is underwater to stop paying their mortgages.

It is important for lenders to maintain as many consequences as they can (foreclosure is a serious consequence), or they will encourage everyone who is underwater to stop paying their mortgages. Principal reductions would be a mistake from this point of view.

It is always important to consider the seen and the unseen effects of an action.

Mike “Mish” Shedlock
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