If you agreed to lend somebody money on the condition that they would pay you back in regular installments, what would you do if they gave you the finger and stopped paying? I bet most of you would sue the person to get back what is rightfully yours. Me too.
Mortgage Modification Madness?
So when I heard last week that Bank of America (NYSE: BAC) was going to forgive up to 30% of the debt owed to it by 45,000 deadbeat mortgage customers, I was shocked. In total, Bank of America is forfeiting $3 billion in loans it is owed. Furthermore, the bank is only offering this deal to mortgage customers who have been delinquent in their payments and who owe at least 20 percent more than their home is worth. If you have been a responsible debtor who has never missed a payment and didn’t buy more house than you could afford, too bad; you don’t get a break like the deadbeats. That’s not fair. But when has life ever been fair?
Forgiveness Has Its Benefits
The real question isn’t fairness, but why Bank of America has voluntarily agreed to forgive debt? From a business standpoint, it would only make sense if the cost of foreclosure was higher than the cost of debt forgiveness. There is an argument to be made for debt forgiveness. Since this program is limited to those homeowners who are “under water” (i.e., owe at least 20% more than their house is worth) a foreclosure proceeding at current market value would, by definition, cause the bank to lose at least 20 percent of their owed debt anyway. Granted, banks can go after the deadbeats later for the difference, or sell the account receivable to a debt collection agency, but collection is far from certain.
Furthermore, foreclosure can take several months to complete, during which time home values could decline even further or the homeowner could trash the place out of spite. One debtor was so angry about being foreclosed that he bulldozed his house rather than let the bank sell it from under him!
Lastly, debt forgiveness would not materially impact the bank’s balance sheet because at least 80% of the loans eligible for the modification program originated with its Countrywide Financial subsidiary and thus are “off balance sheet” assets.
Mortgage Modification Has Some Downsides
On the other hand, there are equally valid reasons not to forgive debt. First, a Boston Federal Reserve study found that around 30% of all delinquent mortgage holders are able to self-cure and pay back their mortgages in full. Second, according to the experience of the Federal Deposit Insurance Corporation (FDIC), which has its own mortgage modification program, 40 percent of borrowers who are given a mortgage modification end up defaulting a second time anyway. A double default results in wasted administrative costs associated with the modification program and the lost time value of money that could have been earned from foreclosing right away and reinvesting the sales proceeds. In other words, 70% of deadbeat loan modifications turn out to be money losers for the banks; only 30% reap the possible benefits mentioned above.
Furthermore, on some of these mortgage loans, Bank of America is merely the servicing manager for investors who bought mortgage securities. Offering debt forgiveness on these servicer loans doesn’t make any sense because servicers are first in line to get paid their fees regardless of whether the loan is paid back and, in fact, make higher fees in foreclosure.
Lastly, debt forgiveness creates a moral hazard whereby responsible homeowners who otherwise would have paid on time decide to default because they want the same sweetheart deal that the bank has given to the deadbeats.
Massachusetts
Taking everything into account, I don’t think debt forgiveness makes business sense, so the question remains why Bank of America is doing it.
The answer lies up in Massachusetts, where state attorney general Coakley (yes, the same Martha Coakley who lost the Senate race for Ted Kennedy’s vacated seat to Republican underdog Scott Brown) was threatening to bring suit against the bank for predatory lending. Massachusetts alleged that Bank of America’s Countrywide subsidiary made “presumptively unfair” mortgage loans to high-risk borrowers, such as pay-option adjustable rate mortgages with negative amortization. Such loans require minuscule monthly payments that don’t even cover the interest on the loan (let alone principal) and actually increase the amount of principal a borrower owes the longer the loan is outstanding.
I have to agree with Massachusetts that no borrower in their right mind would agree to such a loan. Talk about indentured servitude! Of course, a gambling borrower could have been betting on rapidly rising real estate prices to permit a flip of the house to a greater fool for a quick profit. But betting on rapidly rising real estate prices is insanely high-risk and an activity that banks should not have been willing to indulge.
The Smoke Clears
It all makes sense now! Bank of America is forgiving the debt as part of a legal settlement, not because it thinks debt forgiveness – in and of itself – makes good business sense. Come to think of it, if Bank of America had truly thought forgiving debt was a money maker, it would have provided the offer to more than 45,000 of the 1.2 million Bank of America mortgage holders currently in default.
Nope, the only thing that made business sense was agreeing to the legal settlement, which prevented a
Analysts Love U.S. Money-Center Banks
Although some have voiced moral outrage at Bank of America for agreeing to forgive some mortgage debt, calling it a form of shareholder robbery, more thoughtful analysts view the legal settlement as a net positive that reduces uncertainty and lets the bank move forward. For example, Morgan Stanley rates Bank of America its “top pick” among large-cap banks with a price target of $28 per share. Similarly, Standard & Poor’s just added the bank to its “Top Ten” portfolio and has a $22 per share price target.
Personally, I’m still worried that Bank of America might need to do another round of dilutive equity financing to shore up its balance sheet, plus it only pays a nominal 0.20% dividend, so I’m in no hurry to buy. Its corporate bonds, however, look great. As Mark Kiesel, global head of corporate bonds at PIMCO, said recently:
If I could come back as any corporate entity in my next life it would be as a money-center bank. You can borrow money at virtually zero, you make prudent loans and you basically earn that spread.
How exactly does a person come back as a bank?
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