Unintended consequences of loan mods
Second, the picture grows even bleaker – at least for the many investors still owning bonds backed by subprime mortgages – due to the increased calls from Washington for widespread easing of terms on mortgages for people who are having trouble paying them.
There are two types of subprime loans. First, those that are actually owned by investors, often banks. Persuading people to contact their lenders when they run into problems repaying the loans is hard enough. Numerous tricks have been used, including sending modification offers in fancy-looking envelopes which are more likely to be opened. But changing terms is possible and could prevent foreclosure, the worst outcome for lenders, borrowers and the plunging house market.
Then, there are those mortgages that have been securitised. These are not owned by individuals, or banks, but by special “trusts”. In other words, the relationship between the borrower and the lender is between a person and a contract, a piece of paper. Decisions are not governed by someone’s will, but by legal requirements.
And these are, not surprisingly, very inflexible. The threat of litigation hangs over anyone’s head if they lose the trust money, such as allowing people to modify mortgages, only to have them foreclose a few months later. In a world ruled by contracts, litigation rules.
But as loan modifications become more acceptable, there will be less of a concern about being sued. At the moment, it looks like being 90 days overdue could qualify a person for more lenient terms.
Chris Flanagan, securitisation expert at JP Morgan, worries about this. “It may only be a matter of time before larger and larger numbers of honest citicens come around to the idea that paying their mortgage debt may not be very smart.”
One head of a mortgage servicer told me problem loans could rise to over 70 per cent from 35 per cent once people realise they can easily get more favourable terms on their mortgages. This spells huge losses for mortgage-backed securities.
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