Critics of the Obama administration's loan modification proposal say that it would not adequately address consumers' nonmortgage debt loads or the second liens on their homes, and that many borrowers would end up defaulting again.
The proposal, part of a broad housing plan unveiled last month, would subsidize principal or interest rate reductions that lower a monthly mortgage payment to 31% of the borrower's income. But there is no maximum for the total debt-to-income ratio a borrower may carry to be eligible for a modification. Nor is there any requirement or incentive for a consumer's other creditors to write down their loans.
"You're not getting a complete picture of what the borrower can afford to pay if you don't take into account all their debt," said Fred Melgaard, an executive vice president at DRI Management Systems, a Newport Beach, Calif., provider of default management software.
To be sure, industry participants are not objecting to this perceived shortcoming of the plan solely out of concern for the borrower.
The American Securitization Forum, a trade group whose members include holders of mortgage-backed securities, argues that the plan would force such investors to effectively subsidize the holders of second liens or auto and credit card debt.
"Ultimately, consumer debt has to be addressed in certain ways to make any mortgage program effective and fair to any of the interest holders in that debt," said Tom Deutsch, the forum's deputy executive director.
The plan is a work in progress; the White House is expected to release more details on March 4.
And the plan does not completely ignore debts other than the first mortgage. Borrowers whose total debt-to-income ratio, including credit card and auto loans, is 55% or higher would have to get credit counseling before receiving a modification.
Some analysts said that sets the bar too low.
"If you're over 55% debt-to-income, all the counseling in the world isn't going to do a thing," said Laurie Goodman, senior managing director at Amherst Holdings LLC's Amherst Securities Group LP.
Borrowers with such heavy debt loads are "not salvageable," she said.
According to the credit bureau Equifax Inc., roughly 23% of mortgage borrowers have monthly payments for nonmortgage debt — including home equity lines of credit, student and auto loans and credit cards — that total more than twice the payment on their house.
In his speech to Congress last week, President Obama defended the plan against accusations it would help undeserving borrowers.
"It's a plan that won't help speculators or that neighbor down the street who bought a house he could never hope to afford, but will help millions of Americans who are struggling with declining home values," he said.
Of course, an overleveraged borrower could choose to keep paying the modified mortgage while defaulting on other loans. After all, home loans have traditionally stood at the top of the American consumer's hierarchy of payments.
But Michael Brauneis, the director of regulatory risk consulting at Protiviti Inc., a Menlo Park, Calif., credit and operational risk consulting firm, said that as home values continue to drop, "borrowers have less and less tangible incentives to repay these loans."
"It's everyone's expectation that people should pay their mortgage before anything else, but that's easy to say when you don't have credit card collectors hounding you and you might care more about keeping your car than keeping your house," Brauneis said.
Edward Morrison, a law professor at Columbia University, said the Obama administration plan will fail unless it addresses second liens.
Roughly 8.9 million homes have both second liens and debt exceeding 92% of the home's net present value, he said. "There's little incentive to modify the first mortgage if that just frees up cash for the second lien."
Moreover, it is difficult to get holders of the first and second liens to agree on loan modifications, because they have conflicting interests.
According to the securitization trade group, roughly 80% of first-lien mortgages in the United States are held in securities, while 80% of second liens are held by banks.
Morrison has proposed that the government offer second-lien holders up to $1,500 to drop their claim on a property, even if the claim has little value with home prices plummeting and the prospect of receiving nothing in a foreclosure. (Fannie Mae and Freddie Mac currently offer incentives to eliminate problematic second liens.)