Who pays when lenders fail?
If there is any silver lining to the second largest thrift failure in U.S. history, it is this: the IndyMac bank collapse has ironically resulted in the nation’s first foreclosure moratorium. The Federal Deposit Insurance Corporation, after taking over IndyMac, declared it would halt all foreclosures on the $15 billon worth of IndyMac mortgages and modify the loans to keep borrowers in their homes. In one fell swoop, the FDIC did what no presidential contender, governor, or legislator has been able to do: force a moratorium on a significant number of foreclosures.
IndyMac’s dramatic collapse provides two important lessons learned. First, the bank’s failure reminds us that preventing foreclosures helps everyone, including those who did not participate during the mortgage boom. Representing an Assembly district with several IndyMac branches, I know that customers who lost money on their uninsured deposits did so not because of their own doing, but because of a nationwide foreclosure crisis spiraling out of control.
Cities, counties and states are now looking at raising taxes in part because the mortgage meltdown has blown holes through governmental budgets. Preventing foreclosures will help stabilize the economy and avert a cascade of further bank failures. Helping our neighbors stay in their homes helps us all.
Second, the IndyMac failure serves as a warning to lenders that they need to adapt and aggressively modify home loans rather than continue to pursue foreclosures, lest they face the same fate as IndyMac. FDIC Chairwoman Sheila Bair has repeatedly stated that a modified home loan is worth more than a foreclosed loan. Many lenders still are unwilling to act in any significant way on that fact.
The primary reason IndyMac collapsed is because the bank needed capital and could not get it. IndyMac had targeted people with low credit scores and thin documentation. When these borrowers stopped paying and started defaulting on their loans, IndyMac began to lose much-needed income.
Had IndyMac placed a moratorium on foreclosures and worked with troubled borrowers to arrange loan workouts the way the FDIC is doing, the bank would have continued to get a steady stream of funds from the modified loans - or gotten the loans repaid through short sales - and may have survived. This lesson is especially important in the wake of the landmark housing bill passed by Congress.
The centerpiece of the federal housing bill - $300 billion to help troubled homeowners refinance mortgages - is not self-executing. In order to access these funds, the lender must agree to take a loss by accepting approximately 87 percent of the home’s current value, as determined by a private appraiser, as payment. The housing bill will thus fail, unless lenders agree to modify loans.
Unfortunately, lenders have had a poor track record of doing voluntary loan modifications. The California Reinvestment Coalition, in its third statewide survey since last year, continued to find that “lenders are not responsive,” “principal write-downs are not happening,” and “foreclosures continue to be the most common outcome for borrowers in distress.” Lenders’ recalcitrance on modifying loans is one reason foreclosure filings continue to reach historic highs,. According to RealtyTrac, the nation experienced an increase in foreclosure filings of 53 percent in June over June 2007, while California had 68,666 foreclosure filings - a surge of 77 percent - the highest in the nation for the 18th consecutive month.
It is time for lenders to adjust their business model, which is failing them and borrowers. Lenders should immediately place a moratorium on foreclosures until October when the federal housing bill takes effect, hire more staff dedicated to loan workouts, and go through their portfolios loan by loan to prevent as many foreclosures as they can.
Seven banks have already failed this year. Lenders that fail to prevent foreclosures and learn the lessons from the IndyMac failure will only increase their own risk of getting taken over by the FDIC.