Underwater homeowners looking for a bailout from President Obama’s Foreclosure Rescue speech might be wise to think very carefully about all the possible consequences of grabbing the new loan modification offer. The White House press release on the full plan is located here. President Obama’s plan offers homeowners in trouble a helping hand, at the expense of all the other taxpayers who didn’t speculate, but let’s put aside our outrage for now. Instead, let’s look at whether or not the loan modification program is a good decision.

Clearly everyone is in a unique situation but there are some commonalities within the group we’ll call People Seeking Loan Modifications. I am openly stereotyping for the purpose of making this blog article general instead of case study specific. People Seeking Loan Modifications (PSLM) are typically folks who had a certain level of income when they purchased the home, and today that income has been dramatically reduced. Some may be facing a rate increase or a payment recast if negative amortization has pushed the principal balance to, say 115% or 125% LTV. Most purchased at 100% LTV, some decided on interest only loans, or interest only for a set period of time, in order to achieve a lower payment, speculating that future appreciation would bail them out at the next refi. They have two big problems: Negative equity AND an unaffordable payment.  PSLM typically have other consumer debt as well as mortgage debt. When income drops off a cliff, PSLM use credit cards to pay for routine expenses. By only offering a modest rate reduction, I predict that the re-default rate on these new loan modifications will be easily over 50% and I’m being optimistic. A rate reduction only solves half the problem. Their monthly housing expense has been reduced but their other expenses have not gone away. (If When the banks are nationalized it will be a lot easier to offer rate reductions on credit cards and perhaps that will be in the next bailout proposal.) There IS a solution for the typical loan mod seeking homeowner; President Obama wants principal balance cram downs in bankruptcy. Now the homeowner has to make a sacrifice: Trash my credit record for 10 years with a BK in exchange for getting a financial matrix reboot.

The key to whether or not a loan modification under the new program will work rests with the homeowner: What is the homeowner’s income today v. when he/she obtained the mortgage loan? Many of these folks have been laid off, some were living on extended overtime as a regular part of their monthly income, others were commissioned salesmen with flatline commissions during 2008, some had to take mandatory salary reductions, and still others have had NO disruptions in income but were qualified at the teaser rate of an Option ARM. What if the homeowner has no job at all? Does the homeowner get a zero percent interest rate loan? I’m thinking no, so how do we underwrite this loan and make a determination if this loan mod will fail? PSLM are high risk borrowers and re-defaults will likely occur. But the theory goes that if we can slow the foreclosures to the pace of a river instead of a flood, then doing so *might* help stabilize neighborhood home values and prevent even more foreclosures.

The Tim at SB reminds us to consider that when speculation occurs, foreclosures are a natural part of the solution and may not always be a negative, especially when a homeowner is far better off renting a similar home for far less than the (even modified!) mortgage payment. Home values fall and people who can afford to purchase do so. This begs the question: Do modified mortgage payments really help homeowners? The answer is, it depends on the homeowner.

In order to project future performance, it is important to visit past efforts in helping homeowners face foreclosure.  Past performance: FHA Secure: Projected to help 80,000 Actually helped 266. Hope for Homeowners: Projected to help 400,000 actually helped 312. Projections for President Obama’s loan modification program are that it may help 3 to 4 million homeowners. I project it will help far less. Perhaps we’ll break a thousand this time. This new plan appears to be a bailout for the banks, disguised as a bailout for homeowners. Same siren as FHA secure and H4H, she’s just wearing a different dress.

Will this piece of the Foreclosure Rescue package from the President help stabilize falling values? No. Instead, it will just flatten out the cliff diving and extend the pain that much longer.  From CR:

“For homeowners there are two key paragraphs: first the lender is responsible for bringing the mortgage payment (sounds like P&I) down to 38% of the borrowers monthly gross income. Then the lender and the government will share the burden of bringing the payment down to 31% of the monthly income. Also the homeowner will receive a $1,000 principal reduction each year for five years if they make their payments on time. This is not so good. The Obama administration doesn’t understand that there were two types of speculators during the housing bubble: flippers (they are excluded), and buyers who used excessive leverage hoping for further price appreciation. Back in April 2005 I wrote: “Housing: Speculation is the Key [S]omething akin to speculation is more widespread – homeowners using substantial leverage with escalating financing such as ARMs or interest only loans.” This plan rewards those homebuyers who speculated with excessive leverage. I think this is a mistake.

Another problem with Part 2 is that this lowers the interest rate for borrowers far underwater, but other than the $1,000 per year principal reduction and normal amortization, there is no reduction in the principal. This probably leaves the homeowner far underwater (owing more than their home is worth). When these homeowners eventually try to sell, they will probably still face foreclosure – prolonging the housing slump. These are really not homeowners, they are debtowners / renters.