So normally, when you talk about who should take the loss, it’s whomever took the risk, enter fraud, greed and deception all with leverage and everyone is broke except those the Treasury decides to pacify (foreigners and maybe bank CEOs). Taxpayers foot any payouts.

Lawsuits will begin to expose the true numbers involved in all the connected investments, this is why Washington is begging that the suits not be filed.

Homeowner losing his home seems mild in comparison.

I think if workouts were such a cost saver, banks would be all over them. As it is, they only seem to consider the idea when heavily incentivized. Those incentives are coming fast and furious, both as carrots (Hope for Homeowners, TARP patricipation, etc) and sticks (Jerry Brown Countrywide settlement, Barney Frank threats, etc.)

Left to their own devices, banks would act rationally and try to recover the max they can on behalf of their investors. If they don’t, they get sued by the investors.

I do think that banks need to get better at efficiently foreclosing and liquidating REOs. They will, I’m sure.

I will have to agree with you that making one payment would not make the process worthwhile. That was an overstatement on my part.

I do think that your FMV – 10% is a bit optimistic though. Anyone who is behind in their payments is very likely not making property tax payments either. These are attached to the property and not the homeowner so this is an additional cost to the bank. Many walkers are trashing the homes on the way out the door as well. Add in the cost of marketing and realtor commisions and I think you are well over 10% in foreclosure costs.

That being said, the recidivism factor is a tough one to quantify. You can look at someone who is in default and assume that they are a bad credit risk but I don’t necessarily agree. If I was $25k in CC debt and underwater in my home, I would consider the option of stopping mortgage payments and taking that money to pay down the CC debt. Perhaps I can then get the missed mortgage payments put on the back of the mortgage and continue my life debt free (except for the house). IF not, I rent for a few years…debt free. That doesn’t necessarily make me a bad credit risk, just someone who is making decisions which will help my long term financial situation. Does this thought process lead to a higher chance of recidivism? Perhaps, but I think that it is a more direct result of allowing homeowners to buy with no skin in the game. That will always lead to a higher chance of default as their home becomes an investment bought purely on margin with virtually no financial risk.

In response to what I would do if in charge of a loss mitigation dept…I think that I would offer a stepped principal reduction over the course of the loan combined with a fixed rate and possible rate reduction. For example, if I was willing to lower the principal by $60k on a 30-year fixed, at the end of each year of payments I would reduce the principal by $5k. This would last 12 years and would speed up the process of reaching the “break even” point for the owner, give him additional incentive to perform on the loan, and would allow me to write down my losses over the course of 12 years instead of in one year. Just an idea…

“I think that the investor will lose less money by working with the homeowner than foreclosing”

In some cases that is certainly true. And it those cases, it makes sense for the lender to do the workout.

But in many cases it is not true. Often the homeowner can’t afford the loan even if the principal is written down to, say, fair market value less 10 percent. It such cases the lender should foreclosure. But even if the homeowner could make the payments on FMV-10%, why would the lender take the risk of them defaulting again when they could get FMV-10% through foreclosure? It only makes sense @ FMV or even FMV+5%. I, as an investor, would want that premium to compensate for the risk I’m taking (that the homeowner would default again). And the problem with doing the writedown to, say, FMV+5% is that the borrower is FAR more likely to default again if they remain underwater. Thus the risk premium needs to be even higher!
Maybe a variation of a Keynesian beauty contest? http://en.wikipedia.org/wiki/Keynesian_beauty_contest

Of course all bets are off when the Government makes it public policy to never allow a bank to fail (Lehman notwithstanding). Who the hell knows what will happen?

Imagine you’re the guy in charge of loss mitigation. Your job is to recover the max number of pennies for every dollar of the loan. If you think this way, then it all becomes easy:

Borrower stressed but not in default? Great, let them keep paying as long as they can. Maybe they’ll stay current.

Borrower in default due to events that could reasonably be cured in the near future (job loss, etc) but otherwise a good risk? Offer some short term forbearance.

Borrower in default, underwater, and swirling down the toilet? Take the estimated amount you will recover from foreclosure (say fair market value less 10%) and weigh that against what you think the borrower could handle in a workout with principal writedown, FACTORING IN THE LIKELYHOOD OF RECIDIVISM. If you think you can get more through foreclosure, then foreclose.

You say:

“Even if the homeowner only makes one payment after a modification it would be a better deal for the investors”

But that is simply not true. After you’ve gone through the expense of the loan workout and written up the new loan, if the borrower defaults again after making only one payment then you’ve been stiffed again. You lose. Back in line for the 90 day foreclosure moritorium, etc, etc, etc.

A bird in hand is better than two on the line. Especially when the line is proven credit risk.

You argue against modifications in your above post by saying:

“Principal reduction is effectively equivalent to foreclosing on the home and then allowing the homeowner to repurchase the home at the market price (sweet!).”

Your comment equating a principal reduction to a distressed homeowner essentially short selling their house to themselves is accurate. But if the lender is going to lose less via this process than foreclosure (which they almost certainly would), why foreclose? It seems like a foreclosure in this case would be like the lender cutting of their nose to spite their face. I don’t get your reasoning. Some say modifications are not fair to everyone unless everyone gets one, but what does fairness have to do with it? People buy identical new cars at the same dealership on the same day from the same salesman and get them for different prices. Is this fair? Not really, but it is a natural result of a negotiation in which both parties are trying to get their own best deals. This just happens to be a very unique time in our history where the homeowner actually has some negotiating power with the lender. Whether they got this power by being financially irresponsible or not is irrelavent.

“…the MBS holders are better served by foreclosing and getting the best possible price from the open market. This is true even when accounting for the additional costs associated with the foreclosure (legal fees, agent fees, etc).”

How is this possibly true? Even if the homeowner only makes one payment after a modification it would be a better deal for the investors. The market price will not change much in one month. The costs associated with the foreclosure will not change much if at all. Perhaps if the modification reset the clock in regards to missed payments (ie. the homeowner would now have to miss several payments again in order to restart the foreclosure process) this would not be the most cost effective option for the investor. But I highly doubt that a modification which reduced the principal to “fair market value” would be defaulted on in the near future. I believe that most people who are interested in and pursuing a modification are actually wanting to stay in their home long term.

I really don’t think any of this matters though, in the end the lawyers will get all of the money and everyone will take it in the shorts. John Grisham will certainly have a book based on it, Law and Order will do an episode on it, maybe Jack Bauer will even chase down Angelo Mozilo next season. Either way, it will be legal armageddon. Good luck to us all…