In several articles, I point out that loan modification is a no-brainer for lenders. They essentially have the following choices:

• Loan modification

• Foreclosure

• Forbearance

• Deed in lieu

• Short sale

All things being equal, offering a loan modification to borrowers is usually the best option for lenders, because they avoid the high cost of foreclosure (by some estimates $50,000 to $100,000 per foreclosure) and they continue to collect interest on the loan – at a lower rate of return, but still enough to earn a profit.

Unfortunately, in many cases, another factor comes into play – mortgage insurance. If a loan is FHA- or VA-secured or the owners are paying PMI (private mortgage insurance), the lender stands to lose much less from foreclosure, because the insurance will make up a portion of the difference. In other words, the lender’s motivation to work out a reasonable deal with the homeowner/borrower is undermined by mortgage insurance – often mortgage insurance that the homeowner is paying for! When foreclosure numbers spiked, so did mortgage insurance claims. This is what contributed to the need for insurance giant AIG to receive bailout money from the government. Without it they could not have paid all the claims being made and still remain in business. AIG going out of business would have jeopardized the stability of millions of loans and caused even greater market insecurity.

If you are wondering why the federal government is willing to subsidize lenders for modifying mortgages and subsidize homeowners for making their monthly mortgage payments, wonder no more. One reason the government wants to bail out homeowners is because it has to. The government stands to lose more if homeowners with government-secured mortgages default on their loans than by paying ten thousand dollars or so to subsidize mortgage modifications for at-risk loans.

You can also stop wondering why mortgage lenders approved all of those risky mortgage loans in the first place. Risks to the lenders were often reduced by the fact that the loans were insured. They could afford to gamble, because someone else would be there to pick up the tab on any losses.

Having insurance when disaster strikes is usually a good thing, but in the case of the foreclosure crisis, having mortgage insurance can work against you. It’s not like homeowner’s insurance that protects your investment in the case of a natural disaster. It only protects the lender’s investment – leaving you and your family without a roof over your heads. In addition, as a recent visitor to KeepMyHouse.com pointed out, eliminating PMI for loans that require it could make house payments more affordable, put more money in people’s pockets, and help stimulate the economy.

I am not entirely against having the government secure loans or requiring homeowners to pay PMI on certain mortgage loans. Up to this point, these programs have helped more people achieve the American Dream of Homeownership. However, when these same programs are working against homeowners during an unprecedented economic crisis, I think it is time to review the real purpose of these programs. Lenders need to start relying less on mortgage insurance and more on loan modification to mitigate their losses and help more Americans keep their homes.

Published: April 20, 2009

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