A year ago I wrote this article about the government’s plan to freeze mortgage rates and how ridiculous it was. I also suggested that people should just walk away from their gigantic loans and buy something cheaper. A lot has happened since then. There were countless attempts by the government to revive the housing market with very little success, and many people did walk away from their underwater loans and buy cheaper homes. Yesterday, a report released by the Comptroller of Currency showed that more than 50% of borrowers who received loan modifications end up defaulting again anyway.
When I read the news I thought to myself, “well, what did you expect?” Many of these loan modifications either changed the loan term from 30 years to 40 years or lowered the interest rate, but the borrowers still owe a gigantic debt on a depreciating asset. There is no incentive for them to pay the debt if they can find a place to live in for even less money than the reduced mortgage payment. Seriously, who would want to pay a $400,000 debt on an asset that is worth only $200,000?
Additionally, all of these loan modifications encourage bad behavior. The borrowers probably think that if they don’t pay they will be bailed out again because bailouts are all the rage right now. Everyday the news is reporting some kind of government action to deal with foreclosures. So if you already got free housing for 3 to 4 month and then got a modification on your loan, then you have another 3 to 4 months until a foreclosure comes. That’s 6 to 8 months of no housing payments even if there is no second modification, and that seems like a good financial incentive to default.
Another driver in re-defaulting is the worsening economic state of the world. In November the United States lost 553000 jobs, and perhaps a lot of people no longer have the amount of income they had when they received the loan modification. For now, I think the unemployment situation is only going to get worse.
I think the lesson in this is that the government should stop messing with the free market and let foreclosures happen naturally. These modifications and bailouts are just prolonging the pain for everyone involved. I suppose that more than 40% of these borrowers are still paying for their modified loans, but they really may be better off by renting and saving for a down payment on a cheaper home. Home prices have come down more than 25% in many parts of the country, and it is slated to go down even further. It would take a while for a foreclosure to come off someone’s credit report, but that might be the perfect time for that person to build up a sizable down payment.
I think home prices will go down for at least another 4 to 5 years and recover if the government stops with the interventions. If they continue to manipulate the market through interest rates and loan modifications then it may take the housing market a longer time to recover precisely because the bad apples will still be hanging on. For example, if a person gets a foreclosure now then it would take seven years for it to come off their credit report. So in seven years this person would be a prime borrower again. However, if he hangs onto the mortgage through various bank and government deals and then redefaults after two years, then it would take nine years from now for that person to become a prime borrower again. The sooner people get foreclosed on, the sooner they can rebuild their credit and become suitable homebuyers again. The housing market will only recover when the demand returns, and I truly believe that all of these government polices to prevent foreclosure will simply stall the recovery of the housing market.
