It doesn't have to be this way...

The vicious circle of falling prices and rising delinquencies and foreclosures rages on in many markets, with DataQuick reporting yesterday that one in three existing home sales in California during the first quarter involved a foreclosed property. The percentage was even higher -- as many as two out of three homes -- in some markets (see story).

If the lending industry fueled the housing boom, it also holds the keys to getting us out of the resulting bust. There are basically two things lenders can do to help: provide loans when creditworthy bargain hunters decide to get off the fence, and help people who want to keep their homes avoid foreclosure (when that's in the lender's best interest).

Lenders no longer have all that much say about who they extend credit to. Three out of four loans are now purchased (or securitized and guaranteed) by Fannie Mae and Freddie Mac, which have tightened their underwriting requirements. Borrowers who want to put down less than 20 percent will find private mortgage insurers also have tougher standards in place (including no more zero down loans).

There are always FHA loan guarantee programs -- and increased loan limits mean more people can take advantage of them -- but Congress has yet to pass legislation that would further expand the pool of eligible borrowers.

With no end in sight to rising delinquencies and foreclosures, it's hard to blame Fannie, Freddie, private mortgage insurers, and others for tightening their standards. Until the free fall in housing prices some markets are seeing slows down or ends, every loan made without a sizable down-payment entails a risk of an upside down borrower.

While lenders may have their hands tied in helping out on the demand end of the equation, they can do a lot to lessen the pain on the housing supply side. A new report by state banking regulators concludes that in November, December and January, subprime loan servicers only engaged in loss mitigation efforts with about one in four troubled borrowers. The rest were headed for foreclosure (see story).

The idea that lenders -- or perhaps even the government -- would work with delinquent borrowers to keep them in their homes troubles some, who view such efforts as a bailout of borrowers or lenders. Why should lenders forgive part of a borrower's debt -- or the government help them refinance into more affordable loans -- if they bought an overpriced home or didn't read the fine print in their loan disclosures, some critics say.

Many of the proposals that have drawn fire (like Barney Frank's $300 billion FHA refi proposal) because they are perceived as "bailouts" are still being debated by lawmakers and regulators. But the new report by the State Foreclosure Prevention Working Group suggests that lenders who are reluctant to engage in systematic loan modifications or slow down foreclosure proceedings are missing out on the chance to help their own bottom lines. Foreclosures that cost lenders more than workouts may be happening because loan servicers are too overwhelmed to engage in loss mitigation that would be in their best interests, the report finds.

Almost two-thirds of all loss mitigation efforts started are not completed in the following month, the report found, and an analysis of three months of data suggested many never close at all.

"Based on anecdotal reports of lost paperwork and busy call centers, we are concerned that servicers overall are not able to manage the sheer numbers of delinquent loans," the report concluded.

Jack Guttentag, professor of finance emeritus at the Wharton School of the University of Pennsylvania, tackles this issue in his latest column, "Why needless foreclosures happen anyway."

One problem has been the restrictions placed on loan servicers by investors in securities that fund mortgage loans, which may expose servicers to lawsuits. Lawmakers on both sides of the aisle are getting behind bills that would give loan servicers a safe harbor from such lawsuits.

But Guttentag points out other obstacles and disincentives to employing loan modifications, workouts, short sales, and other loss mitigation techniques. They include a shortage of skilled staff, the presence of mortgage insurance, and second mortgages.

While loan servicers like Countrywide Financial have boosted their servicing staffs, the Working Group's report suggests that they are only treading water. Loan servicers are doing more workouts and loan modifications, but delinquencies are rising just as fast, and three out of four seriously delinquent subprime loans are still headed for foreclosure -- the same proportion seen last fall in an previous Working Group study.

In markets where speculators ran rampant, home prices do need to come back down to levels that are supported by fundamentals. But there's also a danger that home prices will overshoot on the way down -- wreaking more havoc on the financial system, and prolonging the day when lenders will be able to extend credit to creditworthy borrowers who want to take advantage of bargain hunting opportunities.

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