Late last month, in an effort to help delinquent IndyMac Bank borrowers stay in their homes, the Federal Deposit Insurance Corp. (FDIC) announced a "systematic" loan modification plan.
The plan is initially aimed at helping 4,000 IndyMac borrowers who are either seriously delinquent or have defaulted on their loans, and then later extending help to thousands beyond that number.
However, the FDIC might be shooting itself in the foot with the widespread modification plan, market sources said, because there is a strong possibility of re-defaults or unintended delinquencies. Borrowers who have loans serviced by IndyMac may use the plan as an incentive to default on their mortgages and secure a lower rate.
"If someone has stayed current but it has been a struggle, and they may actually benefit from a lower payment, why not quit making payments?" said Bert Ely, an independent banking consultant.
There is also a lack of confidence in the effectiveness of a blanket loan modification plan, a source of concern for the mortgage market since the government began streamlined loan modification programs last year.
Implementing mass modifications on an almost mechanized basis challenges good lending practices, market participants said.
"If any mortgage lender did originations in the same manner that the FDIC is doing these modifications, they would be written up for safety and soundness violations," Ely said.
Further heightening the argument against bulk modification programs is the drastic change in the economy that has taken place since many of these loans were created, said Lou Barnes, owner of Boulder West Financial Services, a Colorado-based mortgage servicing company.
"Each household is its own event, so what might work for one household might not work for another," Barnes said. "Each one needs to be reopened individually and examine what the state of the household really is."
These households are also financially weaker or more ridden with debt when compared with prior cycles where strong homes got hit by bad luck, Barnes said. "To accomplish a loan modification these households can actually perform on is going to be so deep that it is not really saving much versus foreclosing on the house."
As a result, the market said it expects to see many of these borrowers re-default, which goes against the FDIC's goal of recovering and maximizing value on these loans.
Despite managing to stay in their homes, borrowers remain strapped by other debt burdens including second mortgages, credit card bills or monthly payments on SUVs that have declined in value. These obligations continue to pile up, preventing a financial recovery for borrowers, Ely said.
"When you go to foreclosure six-months-to-one-year later, you have made the loss even worse," he said.
Bondholder Woes
These re-defaulting mortgages can also exacerbate bondholder losses, Barclays Capital said in a recent report; not only for subordinate bondholders, but also senior holders if many loans in a pool are modified with a high re-default rate.
Furthermore, by reducing the principle balance of the loan, the modification also cuts the interest rate on the mortgage which reduces the value of the loan. Bondholders might be subject to lower coupons or interest shortfalls resulting from these interest rate and mortgage balance reductions, Barclays said. With bonds that have passthrough rates, reducing mortgage rates will directly diminish bondholder interest payments. However, fixed-rate and floater bonds could also be subject to lower coupons and/or interest shortfalls depending on available funds and other caps or floors, the bank said.
This is in addition to the challenges that banks and bondholders will encounter as the FDIC seeks to modify securitized mortgages beyond their servicing contracts. If the FDIC is able to abrogate servicing contracts to modify loans in securitization trusts, banks may be hesitant to do any sort of loan servicing, Ely said.
However, there doesn't appear to be any compassion for the bondholders at the FDIC. "The FDIC's compassion is for the state of the FDIC's fund. The bondholders are an operational impediment," Barnes said.
There is also a question of whether the FDIC has violated its fiduciary obligation as a receiver to look out for the interest of all creditors in this situation.
"There is concern about the cost of this to the banking industry through higher deposit insurance premiums, through an increased loss to uninsured depositors, and an increased loss to other creditors of IndyMac," Ely said.
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