Mortgage Loan Modifications Critical to Obama Rescue Plan

The Obama administration is ready to back a robust foreclosure prevention program. Analysts say that such a program will have to tackle the problem from several angles.

On Food Network's Iron Chef America, competing chefs are given a secret ingredient and asked to prepare five dishes in one hour.  President Obama and his economic team have found themselves in a similar predicament-they're facing an ever-shortening timeline to develop creative, effective solutions for the foreclosure crisis. In this case, the secret ingredient appears to be the loan modification, but no one's really sure how to make it palatable for lenders and investors alike.

Big dollars backing foreclosure prevention

The federal government is in the process of devising a $100 billion foreclosure prevention program. Public details on the program aren't yet available, but it's widely believed that loan modifications will play a central role.

To date, mortgage servicers have been largely reluctant to modify their mortgage loans voluntarily. This reluctance is not rooted in stubbornness, as many homeowners may think. In reality, mortgage servicers may not be clear on whether they have the authority to rewrite the loans they manage. This is a legal complication that arises out of the securitization of mortgage loans, which creates a tangled web of mortgage stakeholders. Even when the servicer does have the authority, such an action could put the servicer in danger of getting sued.  Plus, a loan modification drains the servicer's resources, but doesn't provide any financial compensation.

The Obama plan could deploy two tactics to address these issues:

• Prohibiting mortgage investors from suing mortgage servicers for modifying loans

• Establishing a program whereby the FDIC would make incentive payments to servicers for each loan modification completed

Perception is everything

On top of the legal uncertainties, mortgage servicers are also not convinced that loan modifications are actually effective. History has shown that debt reorganizations of all types have a relatively high failure rate. Chapter 13 personal bankruptcy cases, for example, fail more often than they succeed. And a recent report from two bank regulators indicates that mortgage loan modifications may not be much better; the report showed that more than 35 percent of homeowners were behind on their mortgage payments just six months after receiving a modification.

Solving this issue will be tricky. The Feds have talked about sharing losses on re-defaults, but implementing such a program is rife with problems. Given that the government has limited funds, the program has to find a way to direct the available cash to those who will benefit from the help. Identifying those individuals, and excluding everyone else, has been an issue since the housing crisis began two years ago.  

Ultimately, the successful foreclosure prevention recipe will likely require the perfect balance of several secret ingredients. Obama and his team say they can do it, and homeowners everywhere hope they're right.