Would you modify a loan before default?

The New York Times reports that Bank of America and JPMorgan Chase are sending notices to some of their borrowers with high risk loans modifying the terms of the loan and reducing the principal due on the debt. Not much news worthy here, except, the letter is sent to borrowers who have not defaulted or requested a modification. The banks are proactively overhauling loans for borrowers who have so-called pay option adjustable rate mortgages, which were popular in the late stages of the housing boom but which banks now view as potentially troublesome. In almost all case, these borrowers are substantially under-water. In one reported case, a borrower was told the amount she owed had been cut in half. The bank cut her principal by $150,000 while raising her interest rate to about 5 percent. Her payments would stay roughly the same. She had not complained to the bank about the amount of the loan, had not defaulted, and reported that she would not have defaulted. 

I am not an economist, nor a banker, but as crazy as this sounds it may make sense. Most of these mortgages are possible problem loans acquired through the purchase of troubled banks.  I assume the banks can determine approximately how much they have invested in each of the loans, and perhaps this move is simply a way to insuer they get back at least that investment, plus a higher rate of interest. Waiting until default might not result in a similar result. Debtors in default have already ruined their credit, and have less incentive to work out new terms. They may in fact have already made the decision to move. Working with those debtors may also impose substantial costs on the banks, in terms of staffing. This proactive strike may seem like throwing money away, but it fact could an efficient way of protecting an investment. A move that could benefit both banks and consumers.

 

 

Comments

[Dan]

This probably has to do with the owner of the loan wanting to sell the loan. The loan probably doesn't fit existing guidelines to sell to a third-party, so the servicer/owner makes it conform and sells it to offload the risk. The risk is probably with the taxpayers now.

The threat to consumers is that they may be forced to pay income taxes on the forgiveness of debt. Imagine paying ordinary income tax on $150k for which you have withheld nothing.