Why Mortgage Forgiveness Is Just Loan Loss Recognition In Disguise

As the months have gone by since various politicians, beginning with Hillary Clinton, began calling for either a moratorium on foreclosures and/or interest rate adjustments and forgiveness on some aspects of troubled mortgages, I have given a lot of thought to these suggestions.

Initially, I thought the suggestions of mortgage rate reductions and/or balance adjustments for a period of time, or permanently, to be an unwise intrusion of governmental regulation, a la a 'taking.'

Recently, however, several large banks, including Chase, have unilaterally begun to take these steps. By reducing rates and/or modifying the mortgage loan balances at points in time, these lenders are basically recognizing loan losses in a non-traditional manner.

Rather than classify some mortgages as either defaulted or delinquent, the banks are taking a smaller haircut on a larger base of home loans. Either way, the financial consequence is to reduce the effective rate of interest which accrues as revenue, and potentially write down some loan values.

Last week, my business partner and I were discussing this phenomenon. As we thought about what we, if we owned a bank, would do with a delinquent or defaulted mortgage borrower, it became obvious that foreclosures aren't a good idea in this environment, irrespective of governmental pressure.

With most real estate prices having declined in the past year, and credit availability much worse than it was even three months ago, a foreclosed home has virtually no chance of being purchased at a price that will preclude a significant loss for the mortgage lender.

Instead, if the borrower is still employed and able to pay something, it would behoove a bank to simply treat him/her as either: a temporary renter, with the loan conditions to be reinstated in the near future, making the mortgage loan currently delinquent, or; modify the loan's conditions to equate the borrower's ability to pay with a new interest rate and/or balance, or some combination of the two, and record a loss while the (newly modified) loan remains current and performing, or; modify the loan's conditions to be a combination of the first two, both temporarily suspending the loan payments, then returning to a modified mortgage payment and terms in the near future.

All three options provide some cash flow for the bank, and the ability to avoid foreclosure, evictions, and an overall worsening of the probabilities that the lender can recover looming losses.

Because of the gradual spread of what began as a largely technical issue of requiring securities held by banks, backed by mortgages to be marked to market (rather than allowed to be valued based on their economic potential while partially or wholly performing), eventually, to engulf the entire banking sector in hundreds of billions of dollars of writedowns, resulting in a credit contraction, the environment in which troubled mortgages now exist is much worse than it was last year.

The credit contraction has, of course, affected business volumes, economic growth, and job losses. Thus, by late 2008, the unforeseen consequences of Congress' narrow-minded insistence, in Sarbanes-Oxley, on 'mark-to-market' valuation turned what was initially an accounting matter into a a policy choice which has amplified accounting valuations to the point where they have reached out and damaged the entire US economy.

A year ago, the failure of a couple of Bear Stearns mutual funds, due to this dry accounting issue, seemed manageable. But in time, as investors understandably began to recoil from any structured finance instrument potentially containing recent, riskier mortgages, mark-to-market rules caused a chain reaction which has resulted in a real credit and economic contraction that is many times worse than it otherwise might have been.

In this new environment of fallen home values, few new mortgage loans, and rising joblessness, banks really have no choice but to work out non-performing home loans, rather than simply begin foreclosing on every defaulted loan and displacing residents, to no better effect for the bank, the residents, or society in general.