Loan Modifications For Banks Could Mask Future Losses

NEW YORK -(Dow Jones)- Banks modifying mortgage terms for homeowners could actually undermine the banking industry's return to health by masking possible losses.

Historical evidence suggests that even when lenders modify mortgage terms for at-risk borrowers - cutting interest rates, principal or extending the loan's life - a hefty portion of those borrowers default within a year or two anyway. Besides, in many cases with subprime loans, so many borrowers had so markedly inflated their income status, that even a vastly modified loan still won't make it affordable for their true earnings.

Banks and politicians have been pushing the use of mortgage modifications as a way of keeping at-risk borrowers out of foreclosure. They hope that will stanch the steep nationwide slide in housing values. Loan modifications can also provide some accounting and earnings relief for banks, since lenders can re-list many modified delinquent loans as current loans, so long as the borrower resumes regular payments once the loan is modified.

Many industry officials say loan modifications will help a large number of borrowers avoid foreclosure, since banks are working to identify at-risk borrowers before they default. They are focusing intensely on borrowers of adjustable rates mortgages whose rates are soon scheduled to reset higher. Just two weeks ago, for example, JPMorgan Chase & Co. (JPM) disclosed that it prevented 250,000 home foreclosures since it started to actively modify mortgages in early 2007.

But loan modifications have shown a glaring historical weakness: According a 2007 Fitch Ratings report, 35% to 40% of borrowers default on their modified loans within 12-24 months. Research from Moody's Investors Service and other firms have found similar, albeit bleaker, statistics. Both the Fitch and Moody's reports collected information from mortgages that lenders sold to third-party investors via mortgage-backed securities, and those pools of mortgages include both prime and subprime loans.

Dr. Joseph Mason, a banking professor at Louisiana State University's business school, aggregated that data in a report last year that critiqued the practice of modifying loans. He puts the benchmark success rate for modified loans at 50% .

Mason says, furthermore, that there isn't yet evidence to suggest that banks will see lower re-default rates among mortgages sitting on their balance sheets, as compared to loans sitting in mortgage-backed securities.

"Unless we get into skewed outcomes," where bank-held loans outperform securitized loans, "or vice versa," he says, "then we wouldn't expect to see any difference."

But federal banking regulators, including the Federal Deposit Insurance Corp., and even Federal Reserve Chairman Benjamin Bernanke, have nonetheless been pushing banks to offer modifications to mortgage borrowers.

"The FDIC believes modifications should be systematic and sustainable," a spokeswoman for the FDIC said.

What's more, the FDIC is itself working to modify mortgages written by IndyMac Bancorp Inc. (IDMCQ), the California bank company that the FDIC seized in July - at the time, the largest bank failure in the nation's history.

"The modified (IndyMac) loans will be underwritten to an affordable debt-to- income ratio" of 38%, said FDIC Chairman Sheila Bair, in an August statement. That means the FDIC will modify IndyMac borrowers' loans in a way that a loan's monthly payments are equal to 38% of a borrower's monthly income.

But Mason cites research suggesting that borrowers substantially inflated their incomes in about 70% of loans, meaning it may be highly difficult to modify many loans in a way that reflects the borrowers' true incomes - as opposed to the incomes borrowers submitted on the original loan applications, often with the help of mortgage brokers or loan officers.

"If modifications are given to borrowers that are not well suited for homeownership in the long term," Mason writes in his report, "the loan modification only serves to delay the inevitable."

And yet, banks struggling with rising delinquencies may be able to use modifications as a way to re-list delinquent loans as current, and thereby disclose stronger balance sheets.

Some banks have undertaken conservative policies to ensure that modified loans are not re-classified as current loans, only to lapse back into default within months, and produce yet another spike in so-called "nonperforming" loans, or loans in default.

Both Wells Fargo & Co. (WFC) and Wachovia Corp. (WB) - which Wells Fargo is set to purchase by year's end - wait until borrowers have made six consecutive payments on a modified loan before they classify such a loan as current.

There is no specific requirement for how many payments borrowers must make before banks can re-classify a modified loan as current. While Wells Fargo and Wachovia have adopted decidedly conservative standards, banks are apparently free to adopt less stringent policies, and more quickly re-classify modified loans as current. Such practices could later produce a spike in reports of bad loan.

Lana Chan, an analyst at BMO Capital Markets, therefore says that loan modifications could "potentially be delaying the inevitable."

Taken from : http://money.cnn.com/news/newsfeeds/articles/djf500/200811181400DOWJONESDJONLINE000588_FORTUNE5.htm