FDIC Practices What it Preaches: IndyMac Loan Modifications Are On Their Way

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This afternoon FDIC Chairman Sheila Bair and her team took the next important step in making good on their promise to treat borrowers whose loans are held or serviced by IndyMac as the Chairman has urged other banks to treat their borrowers. Simply put, the FDIC announced a blanket loan modification program, under which the loans of borrowers in default or having trouble making their mortgage payments will be automatically modified into fixed rate loans whose terms will be set so that housing debt consumes no more than 38% of the borrower's income.

Many of the loans covered will be Alt-A loans, the kind that enabled borrowers to pay no interest for the first few years of the loan, leading to payment shock when that period ended that can far exceed the already substantial shock on a sub-prime loan that resets from, say, 7% to 10%.

Most of the loans will be modified into fixed rate loans for the remaining term of the loan at the interest rate of similar-term conforming loans (currently about 6.5%). If that still yields too high a payment, the loan will carry a lower interest rate for 5 years, and then will gradually increase to the conforming rate. The modifications come with no fee or other charges.

The critically different thing about this plan is that it's automatic. The FDIC is conditionally modifying the loans before the borrower even says "help!". All the borrower needs to do to seal the deal is to send in a check for the new loan amount and a verification of the borrower's current income. And this is no "pilot" program: the first round of modification letters will go to 4,000 people.

This step on the FDIC's part is apparently based on the joint premises that (i) when an Alt-A (or indeed, a sub-prime) borrower gets into trouble, the trouble is very big and cannot be resolved without a major restructuring of the loan; (ii) foreclosure, especially in the California markets in which most of IndyMac's loans are located, is almost always a far worse proposition economically for the bank (and the FDIC), as well as for the borrower, than getting principal on the loan repaid; and (iii) the borrowers at issue will be both willing and able to live up to their new obligation. As yet, there's no indication the program will include reductions in principal. Given the ups and downs of the housing market in general and in California in particular, that may be an important limitation on the program's success in avoiding foreclosures.

Nevertheless, this is a bold and important move on the FDIC's part. If it succeeds, it will not only demonstrate that Chairman Bair has had it right all along (which undoubtedly will make her feel somewhat better about the fact that her proposals have not gotten the traction they should have), but more importantly, it will set the stage for all those other banks to follow suit. See "Indy Mac's Next Role: Modification Test Case," American Banker (Aug. 14, 2008). It will be critical that the FDIC keeps us fully informed of what it is doing, and what the results are, including the extent to which there are re-defaults. And it will also be helpful if the FDIC's examiners in other banks don't discourage any other institution that wants to, from emulating the mother ship.