Loan modification and a test of human nature

The FDIC has been pushing a loan modification program whereby there will be wholesale modifications by the servicer like the IndyMac structure used by the FDIC. The loan modification program would use an assessment test to adjust the loan payments to be a percent of income. The proposal would set loan payments at 38% of income.

We will not discuss the moral hazard problems associated with allowing everyone who over extended themselves to have an affordability test. The policymakers are beyond that point. The more relevant issue is the human nature of the existing borrowers. Many of the home now have negative equity given the sharp decline in housing pricing in many areas. The test of human nature will be whether the affordability test is met and the adjust of payments is granted but homeowners do not want to own an underwater asset.

If homeowners walk because of negative equity, then an affordability test will not be effective. So, the question is whether borrower view their home as a consumption good or an investment good and what is the time horizon for their investments. Do you make payments on a losing investment even if the payments are lower. Chairman Bernanke is worried about this issue. We will have to see what is the nature of the borrower, but my guess is that default will decline but not as much as expected.The amount of defaults after modification is still high and the government will be stuck with the assets.