Popular mortgage "mods" fuel moral hazard

By Al Yoon and Walden Siew - Analysis

NEW YORK (Reuters) - Mortgage companies scrambling to ease the terms on thousands of loans destined for default may be doing more harm than good by rewarding investors and homeowners who took on excessive risk.

Efforts to help Americans pay their mortgages have forced companies such as Countrywide Financial Corp CFC.N, the largest U.S. mortgage lender, to expand their practice of loan modifications, which lower payments for borrowers vulnerable to foreclosure. Countrywide on Tuesday said it would refinance or modify $16 billion of loans.

While such concessions are largely a win-win situation for the parties involved, since homeowners keep their homes and the bank reduces losses, the practice may exacerbate a credit crisis that began in July and is leading to growing cries of foul in the $7.2 trillion mortgage bond market.

To some, the loan adjustments are little more than a bailout of bond buyers who were paid to take greater risks. The practice of lowering interest rates or forgiving a portion of the principal could even encourage more of the bad lending that helped create the U.S. housing bubble and subsequent credit crunch.

"Over the long run, if you get wide loan modification supported by the official community, that encourages a resumption of risky lending to risky borrowers, which brings us back to how we got here," said Christian Stracke, a senior credit strategist at research firm CreditSights. "It's a subsidy for risky behavior."

Countrywide said its action would affect adjustable-rate mortgages for 82,000 borrowers who face higher payments to keep their homes.

Making loans current today that might go bad later may improve the short-term performance of the bond, triggering a liquidation of reserves for those who are supposed to shoulder the biggest risks. This eliminates important protections for more conservative investors, again rewarding the reckless.

The release of reserves on a bond deal typically occurs if enough underlying loans are current after a period of three years. With the worst of the bonds being created in late 2005 and beyond, the issue is likely to heat up toward the end of 2008, said Roelof Slump, a managing director at Fitch Ratings. He added that some modifications may have been done in recent months to massage performance on older bonds.

With billions of dollars tied to results of performance tests, measurements of good standing are drawing more scrutiny. In addition to servicer discretion over how modifications are recorded, the companies also don't have uniform guidelines on when to report loans in default.

A group of hedge fund managers in June accused Bear Stearns Cos. BSC.N of going a step beyond mere modifications and simply buying bad loans out of some bonds to boost their value. Bear Stearns denied the allegation, according to a Wall Street Journal report.

The potential that lenders will be blamed for such self-serving modifications is "huge," Garry Cipponeri, a senior vice president at Chase Home Finance, said among panelists exploring "moral hazards" of the transactions at a Mortgage Bankers Association meeting in Boston last week.

Investors who own the highest, AAA-rated portions of bonds have already voiced their opposition to loan modifications for investors in lower-rated securities in "many" instances, said Ted Tozer, National City Mortgage's head of capital markets, who sat on the MBA panel with Cipponeri.

"The AAA holders say 'why are you doing these mods?' We say we are servicing loans for the whole security," Tozer said.

POLITICAL SUPPORT

The movement to modify mortgages has also gained political backing in recent months as legislators push for ways to staunch an alarming rise in foreclosures. The loans, by and large, were created during the housing boom under loose underwriting standards. In many cases, lenders demanded no proof of income or extended credit to borrowers financing more house than they could afford.