"Households and investors may be holding out for better terms, bigger bailouts and for investors to be made whole"

Thomas F. Cooley on Forbes considers mortgage relief efforts:

"According to the most recent data, as many as one in 10 mortgages in the U.S. are delinquent or in foreclosure. The continued decline in housing prices has been exacerbated by the decline in the economy. The housing sector is caught in a continued downward spiral.

Foreclosure is a slow and costly process and represents significant dead weight loss for the economy. Estimates are that the cost of foreclosure is 30% to 35% of the value of a house. Moreover, there are externalities that are associated with properties that do foreclose in that they contaminate the value of neighboring properties. This issue is also critical because reducing losses to default and foreclosure will help stabilize the financial system by reducing the actual losses--and the uncertainty about them--that are passed through the financial system to the holders of the mortgages and mortgage-backed securities. Default losses are concentrated in the "first loss" and mezzanine tranches of collateralized debt obligations, which has made them highly toxic to the financial institutions holding them."

I didn't know that about CDOs.

"Here is the question: Given the attention that has been devoted to the problem of troubled mortgages and the number of programs that have been put forward to address them, why so little impact? The simple answer is that the programs are badly designed.'

How so?

"Some examples: Hope for Homeowners is a Federal Housing Administration program designed to modify existing loans by writing down the principal, offering insurance against further default and introducing shared appreciation on the property. Fannie Mae and Freddie Mac laid out plans for restructuring mortgages that lower payments but extend the term on the loan or involve balloon payments. The Federal Deposit Insurance Corporation (FDIC) has proposed to restructure troubled mortgages by lowering payments, but with no write-down of principal and with a balloon payment due at the end. So far, the response to these programs has been minor. Why?

First, they start with lousy incentives. Both Hope for Homeowners and the FDIC programs are available to homeowners who are delinquent by several months in their payments. If you want to restructure your mortgage, what does this tell you? Stop making payments! Sensibly, most bank restructuring programs require borrowers to show good faith by keeping payments current before they will consider restructuring."

It's not smart. However, wouldn't this incentive theoretically lead to more people taking advantage of the offer?

"Another problem is that restructuring per se is not a great solution. For the most part, it simply kicks the can down the road. Lowering current payments but requiring either a balloon payment or an extended payback term postpones the problem without solving it. Moreover, since it does nothing to address the negative equity of the homeowner, it increases the probability of secondary default if prices or owners' incomes continue to fall. For all of these reasons, owners become essentially like renters, with all of the adverse incentives that may imply."

It's not a great solution, but we're not looking for great here.

"The existing approaches to loan modification do not balance the incentives of the borrowers and the lenders. Shared-appreciation mortgages (which are a component of the FHA plan) do this well. Shared-appreciation restructurings offer a debt for equity swap whereby, in return for modifying the loan, the borrower must give up some of the future appreciation in the value of the property. Designed properly, this would discourage borrowers from seeking modifications if they can continue to pay their mortgage."

This would seem to be a good plan.

"The biggest obstacle to loan modifications by far is securitization--the fact that an estimated 80% of the troubled loans have been sliced and diced and sold to many investors. This gets in the way of servicers who might otherwise be given incentives to modify loans in ways that are in the best interests of society. Existing commercial law allows loan servicers to make only changes that are in the holder's best interest--"not materially adverse to the Owner." The law also says that if a mortgage is in default or in the servicers' opinion close to it, then servicers have no authority to make changes in interest rates, or principal amount, or time of payments."

This is a problem, although people seem to disagree on how big it is. Servicers might have more leeway than many have assumed, and are simply using this problem as a bargaining chip.

"Could Congress pass a law that allowed servicers to modify loans by invoking a standard such as "a good faith effort to advance the collective interests of holders"? Possibly it could, but it may run into the problem that the constitution provides that "Congress shall make no law impairing the obligations of contract."

That's problematic.

"The most important role for public policy is to provide incentives for servicers to restructure and modify loans, to make certain that shared appreciation contracts are part of the policy mix, and to address the legal barriers to modifying securitized loans. It may well be that policy inaction and dithering is the largest barrier to progress to date. Households and investors may be holding out for better terms, bigger bailouts and for investors to be made whole. If so, it is simply because the leadership in Washington has been unable to focus on an unambiguous approach to the problem. In the meantime, neighborhoods collapse."

That's been the real problem. People are waiting for government largess. It's a terrible problem, because, politically, it doesn't look good if the government isn't seen as trying to help homeowners as well as financial concerns. Everybody in this process knows that. That's why there has been no solution. There's no good compromise available as yet. Somebody is going to have to blink.