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Ever since the housing bubble burst, homeowners around the country have suffered big declines in the value of their homes. Yet after years of trying to help out struggling homeowners deal with the consequences of being underwater on their mortgage loans, the federal government is once again trying to push a program that has thus far proven unsuccessful in having any significant impact on the problem.
Same ol' song and dance
According to reports, the federal government is trying to force mortgage servicing banks, including Wells Fargo (NYSE: WFC ) , Bank of America (NYSE: BAC ) , and JPMorgan Chase (NYSE: JPM ) , to write off some of the outstanding principal on mortgage loans for borrowers whose homes have a value less than what they owe on their mortgages. In coordinating various federal agencies and state officials, the hope is that banks will be given a choice: Pay as much as $20 billion in fines, or agree to modify mortgages to forgive that much outstanding debt for homeowners in danger of losing their homes.
Moreover, banks would have to eat those losses themselves rather than passing them on to other investors. That would protect not only buyers of mortgage-backed securities but also Fannie Mae (OTC BB: FNMA.OB) and Freddie Mac, the theory being that it was the banks' mishandling of foreclosure procedures and other technicalities that caused problems in the first place.
All of that sounds reasonable enough. Unfortunately, we've been down this road before, and so far, it hasn't led to a long-term solution.
Failures of the past
As early as February 2009, government proposals to make modifications to mortgages were under consideration. Early versions of the mortgage modification plan essentially rewarded those who took irresponsibly aggressive loans with free money by funding easier payment terms without demanding a portion of any future price appreciation. Later, the government changed the program to include homeowners who were even further underwater on their mortgages, allowing refinancing up to 125% of the home's current value.
But banks granted relatively few modifications under the program at first; in the first six months, only JPMorgan Chase, GMAC (now Ally Financial), and Citigroup (NYSE: C ) granted modifications to more than 6% of eligible mortgages. And among those modifications that banks did make, a huge percentage of homeowners ended up defaulting again even under the modified terms. The reason: Lower monthly payments and more attractive interest rates didn't change the fundamental fact that with their homes worth far less than the amount they still owed, homeowners had a financial incentive not to repay their mortgages. As a result, at several banks, including B of A, PNC Financial (NYSE: PNC ) , and US Bancorp (NYSE: USB ) , the percentage of trial mortgage modifications that became permanent was well below 1%.
Getting it right?
The latest version of mortgage modification at least attacks the underwater-mortgage problem head on by focusing on principal reductions. But the question of who should benefit from any government-mandated settlement will once again reopen the debate about the moral hazard of rewarding those who arguably took the biggest gambles in purchasing their homes in the first place. The fact that the money to fund the principal reductions will come not from taxpayers but rather from the banks themselves should address many people's concerns, but even $20 billion will only go so far. Figuring out who's deserving of help and who isn't promises to be a very controversial issue.
The huge mistakes that mortgage servicers made at both ends of the loan documentation process, whether in accepting questionable information when granting loans or robo-signing foreclosure documents, certainly seem to warrant some form of punishment. But tying penalties to arbitrarily benefit some homeowners over others isn't the right answer. Only once banks and homeowners both admit that home prices aren't going to rebound enough in the near future to save their mortgages from collapse will they both have the incentive to find a lasting solution.
Be smart about buying a home and finding the right mortgage. The Fool's Home Center has all the answers you need to get started today.