The Obama administration relaxed the requirements for government-backed mortgage modifications yesterday. The program, a $75 billion assistance plan announced earlier this year, originally allowed homeowners with loan-to-value ratios up to 105% qualify for refinancing, provided the loan is backed by Fannie Mae (NYSE:FNM) or Freddie Mac (NYSE:FRE). That limit has now been upped to 125%.

The rationale here is simple: As home prices keep nosediving, more and more homeowners are grossly underwater (they owe more than their home is worth). The original mortgage modification program was failing to help as many people as Washington wanted.

And focusing on housing makes sense from a recovery standpoint. This mess started in housing, and it'll surely end there. The root pain of everyone from Citigroup (NYSE:C) to Best Buy (NYSE:BBY) to Home Depot (NYSE:HD) is all linked back to housing in one way or another. As Warren Buffett recently noted, fix housing and "the world will change in a big way."

But -- and this is a very significant but -- past evidence of the effectiveness of mortgage modifications is really, really atrocious. A recent report by the Office of Thrift Supervision and the Comptroller of the Currency detailing the amount of redefaults, or troubled loans that find their way back into default after modification, shows just what I'm talkin' about.

Of the modified loans 30 or more days delinquent, here's what it found:

Modification Date (2008)

Three Months After Modification

Six Months After Modification

Nine Months After Modification

12 Months After Modification





















Source: Comptroller of the Currency, Office of Thrift Supervision, June 2009.

One year out, over 60% of modified mortgages end up where they started … in default. What's really amazing is how quickly things reverted: Just 90 days after modification, almost half of mortgages were back in default. That's utterly pathetic.

Rising joblessness is the most obvious answer to why so many modifications fail. But that alone hardly accounts for the ungodly redefault rate. When unemployment goes up a few percentage points while redefaults hit 60%, something else is surely at play.

And it is
One of the big factors fueling redefaults is just what the Obama administration seems to be pooh-poohing: underwater homeowners.

When your house is worth less than your mortgage, there's a huge incentive to give up and walk away even if you can make your monthly payments. The logic here is simple: The beauty of homeownership is based on a saying that goes something like "with every mortgage payment, you'll own a little bit more of your house." But when you're underwater, the only thing you "own" is the liability. Monthly payments decrease your debt, but you still don't own one inch of the house. The bank does.

Taking away this fundamental sense of ownership zaps the incentive to keep making payments. The sensible thing to do, many find, is to stop paying and walk away. This is suicide on your credit rating and a nightmare for housing-heavy banks like Wells Fargo (NYSE:WFC) and Bank of America (NYSE:BAC), but the pros often outweigh the cons. When the job market is this tight, becoming mobile again is worth its weight in gold.

When it comes down to it, high monthly payments aren't what are pushing many homeowners into default. It's the fact that their mortgage balances are so high that it doesn't make sense to keep making payments.

Moving on
Now back to our Office of Thrift Supervision report. In the first quarter, a scant 1.8% of modifications actually reduced mortgage principal -- the kind of alteration that entices underwater homeowners to keep making payments. Most were interest rate reductions, or capitalizations of missed payments and fees. The latter is literally just taking debt you owed yesterday and tacking it on to what you'll owe tomorrow. Sober people think this is an effective way to solve an excessive debt problem. Honestly.

And that's why the redefault rate is so high: Underwater homeowners are still highly incentivized to default, even with reduced monthly payments. And as home prices fall, their ranks are growing by the day. Modifications in their current form are, more often than not, just delaying the inevitable.

This all loops back to a painful reality: The only way to climb out of the housing mess is to let prices find a true bottom. Ultimately, that means those who bought homes they could never afford will have to bite the bullet and move on. There's really no way around that.

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