Look how far we've come, Fools: One year ago, banks were ridiculed for making so many bad loans. Today, they're being threatened with fines for not making enough.

Earlier this year, the government enacted a $75 billion stimulus program to entice banks to modify mortgages. So far, the program has been a dud. In order to ensure that banks and mortgage servicers are doing their part, the Treasury warned on Monday that those not modifying fast enough "will be subject to consequences which could include monetary penalties and sanctions."

Modify more mortgages, or be fined. Yikes. This is serious business. But why is the program failing so hard that banks and servicers have to be threatened with fines?

First, the numbers. There are two phases to the modification process: the trial modification, where a bank or servicer modifies the loan, and a second step, in which the modification is made permanent. In order to become permanent, borrowers have to make three on-time payments and document their financial condition.

So far, trial modifications have been on fire:


Trial Modifications Granted (cumulative)

May and Prior  












Source: makinghomesaffordable.gov.

No complaints there. The original goal was to hit 500,000 trial modifications by early November. Done and done.

Permanent modifications are another story. Data is hard to come by -- the Treasury conveniently leaves out current figures -- but with straight faces, the Treasury and Department of Housing and Urban Development recently predicted that 375,000 trial modifications will be made permanent by year end.

Now here comes the punchline: The Congressional Oversight Panel reports that from March until September, only 1,711 trial modifications were made permanent. Ouch.

Among these 1,711 permanent modifications, just one small servicer, Ocwen Financial Group (NYSE:OCN), claims it alone accounts for 44.6% of the total. Back out Ocwen's percentage, and the rest of the mortgage industry made a nearly insignificant number of trial modifications permanent.

So what, you ask, is tripping up permanent modifications? Let's count the ways:

1. They don't work
The numbers on modification redefaults -- mortgages that fall back into default after being modified -- are atrocious:

Modification Date

30 Days Delinquent, 3 Months after Modification

6 Months after Modification

9 Months after Modification

12 Months after Modification

First Quarter 2008





Second Quarter 2008





Third Quarter 2008





Fourth Quarter 2008





First Quarter 2009





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

Odds are a modified mortgage will fall back into default before long -- maybe even before it has a chance to become permanent. Let's say the Treasury is right, and by year's end, 375,000 trial modifications become permanent. If the trend in redefaults stays the same, 240,000 or so of those mortgages will end up back in default within 12 months. Hip. Hip. Hooray.

2. Banks aren't dumb
Okay, most are. But knowing the odds that a modification will redefault, some banks might find it worth foreclosing today, rather than waiting a few months and foreclosing on a home that continued to lose value. They want to do this like a Band-Aid: Rip it off, get it over with, and move along. The slower you pull, the more it hurts.

3. The trial modification was a joke
As shown by the threat of looming penalties, banks and mortgage servicers are under pressure from the Treasury to get trial modifications out the door.

Quantity over quality, in other words. A good example of this comes from The Washington Post, which reports that Bank of America (NYSE:BAC) started issuing trial modifications without "getting all the documents first" from borrowers in order to make up for being "slow out of the box."

How many of these take-my-word-for-it trial modifications will end up going nowhere? Who knows. But if you remember how the no-doc lending craze of 2003-2007 turned out, it probably won't be pretty.

4. Wrong target
Plenty of homeowners might think a mortgage modification will bury their housing nightmare for good. Plenty also realize that post-trial modification, they're still in over their heads.

Most modifications either capitalize missed payments back onto the loan balance, or reduce monthly payments with lower interest rates or extended amortization (read: kicking the can down the road).

But precious few modifications actually reduce the principal balance owed. And lower monthly payments don't change the fact that you owe $X, while your house is worth half of X, and that you could be making minimum monthly payments for decades before that changes. Once homeowners realize this, it's often rational to hand the keys back to the bank and walk away.

Leave them alone!
Let's cut to the chase: Penalizing and fining banks for not modifying enough loans is insane. It's dangerous. It's unfair. And most important, it's ironic. This crisis came about after myopic banks like Citigroup (NYSE:C) pushed through shoddy loans as fast as humanly possible. Now we're talking about penalizing banks for not doing this.

There are banks that kept their noses relatively clean during the boom years. JPMorgan Chase (NYSE:JPM). Wells Fargo (NYSE:WFC). BB&T (NYSE:BBT). US Bancorp (NYSE:USB). The last thing we want is to impose penalties on these banks for not lending stupidly enough.  

Fool contributor Morgan Housel doesn’t own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.