WASHINGTON — The Federal Deposit Insurance Corp.'s plan to speed loan modifications has generally won positive reviews from consumer groups and lawmakers who want the Bush administration to implement it quickly.
But experts say these changes would maximize the plan's impact: force servicers to participate by making the foreclosure process more onerous; allow investors to profit more from a housing recovery; pay servicers up front to help lower monthly payments; and grant servicers legal immunity for workouts.
"You need to make sure that the homeowner is ultimately served appropriately, but you do it in a way that minimizes the use of government funds and doesn't hurt the investor," said William Longbrake, a director of First Financial Northwest Inc. in Renton, Wash., and a former vice chairman of Washington Mutual Inc. "It's all a balancing act, and the best way to get there is put smart people in the room … and have them work through the details."
While the White House has balked at the FDIC's idea of establishing a government guarantee of up to half of a modified loan's losses — to spur more modifications — President-elect Barack Obama has shown clear enthusiasm for loan workouts and may put the plan into action.
"We've got to start helping homeowners in a serious way to prevent foreclosures," he said at a press conference Wednesday. "The deteriorating assets in the financial markets are rooted in the deterioration of people being able to pay their mortgages. … That's an area that I'm particularly interested in."
But exactly how his administration would get there is unclear.
Current policymakers, including Federal Reserve Board Chairman Ben Bernanke, have agreed that more aggressive modifications are needed.
In a speech last week, Mr. Bernanke said foreclosures come with a "substantial social cost" in addition to the borrower's misfortune, and cited the FDIC plan along with other proposals to increase workouts. He said that, rather than just share in losses, the government could actually bear some of the costs up front of reducing a borrower's mortgage payments.
If the Obama team were to adopt the FDIC plan, observers said the new administration would have to address whether the plan, hatched by FDIC Chairman Sheila Bair, solves disputes between investors and servicers over the leeway allowed in servicing contracts to restructure loans.
Though the government guarantee — as well as a $1,000-per-modification fee to cover servicer costs — were seen as incentives to satisfy both parties, observers said servicers may still back away because of a requirement that they systematically consider modifications across their portfolio — rather than taking a loan-by-loan approach — to qualify for the guarantee.
A servicer is "only eligible if you apply it to your entire portfolio," said Laurence Platt, a partner in Washington with K&L Gates LLP. "We know that some servicing agreements would prohibit this. It's completely illusory if that's a requirement."
More servicers might take part "if they weren't being required by the government to breach private contracts," Mr. Platt said.
But Michael Krimminger, a special adviser for policy at the FDIC, said a systematic review is critical.
"The idea of requiring a systematic review of mortgages to participate is designed to prevent there being a cherry-picking of making only the worst loans go through the government guarantee, imposing more losses on the government," he said.
He said allowing servicers to pick and choose loans "is simply not a justifiable position from a public policy perspective."
Andrew Davidson, a consultant for investors in mortgage-backed securities, said policymakers should create a safe harbor for servicers worried that investors will sue them if they carry out broad modifications.
"The government would say: 'This is a fair program. We're entering into it on a fair basis. We think it's fair to investors, and if you want to sue, that's fine, but sue us,' " said Mr. Davidson, who founded and runs Andrew Davidson & Co. Inc. of New York.
Some observers saw the plan's restriction on underwater mortgages as impeding participation. Under the plan, loans would generally receive no more than a 50% guarantee from the government after being modified and performing for six months. But loans worth more than the underlying property would only be eligible for a 20% guarantee.
"There are a huge number of mortgages underwater, and in some parts of the country they are badly underwater," said Patricia McCoy, a law professor at the University of Connecticut. "On the other hand, the government is very concerned about the moral hazard of guaranteeing at 50% of face value in circumstances where inflated appraisals drove up the initial principal value of the loan."
Mr. Krimminger said that, although the agency sees a benefit in principal writedowns for modified loans, the servicing agreements do not always allow them.
"We don't have an objection to writing down principal where it can be done," he said. "What we're trying to do is have a proposal that fits most effectively under the securitization contracts that exist today. They make it very difficult to write down principal."
He added that restrictions on the guarantee are simply the result of a need to limit taxpayer expense. "Some aspects of the proposal are an issue of trying to balance maximizing the number of servicers who would want to take advantage of it, versus minimizing the public cost," he said. "You certainly can increase the public cost by running a greater risk of redefault."
Other observers questioned whether, despite the guarantee, investors would realize a sufficient financial gain from the plan.
Jeffrey Naimon, a partner at Buckley Kolar LLP, said an additional incentive would be allowing investors to share a piece in the collateral underlying securitized loans, so they could still profit if the property appreciated and the borrower had refinanced after receiving a modification.
"Finding ways to employ a shared-appreciation component … for investors will make it easier for investors to rationally view a modification plan as being in their interest," Mr. Naimon said.
Other possible impediments to maximizing the plan's potential include making servicer participation voluntary, said Alan White, a law professor at Valparaiso University. Even though Ms. Bair's plan is "designed to take away excuses servicers have for not doing more aggressive mods … it doesn't compel them to do any," he said. "There's more carrot than there used to be, but I think you still need a stick."
Prof. White said the government has the opportunity to press harder for modifications of loans in which the government has a stake. "You could also combine the carrot with the stick, and the stick consists of making it much harder to foreclose," he said.
One way to do that is through foreclosure freezes like those proposed in some state legislatures. "States have already erected to hurdles to foreclosure," he said. "There are ways to either stop foreclosures altogether, or slow them down," he said. "Both of those things make the foreclosure side of the equation less attractive, and insured modifications look more attractive."