Sunday, June 21, 2009

Workout Strategies: “The Boss has Lost It!”

Suppose you were the only wealthy member of a very large extended family. A kidnapper takes a niece – would you pay the ransom? Of course you would. The next week the kidnapper takes a nephew, and you pay again. The third week a cousin is taken, and you realize as wealthy as you are, you can’t pay for everyone’s return. How do you break this cycle?

For lenders, loan modifications are like this. If you go strictly by the numbers, a lender will almost always lose more from foreclosing on a property than by modifying the loan. Going strictly by the numbers, however, is a slippery slope for lenders, because if borrowers believe you will always modify, you will end up modifying every loan. How do you deter the threat of default if borrowers believe you will always modify the loan to avoid a default?

One strategy is to act crazy. Ethan Bronner believes this was the strategy Israel adopted in it’s assault on targets in Gaza in December, 2008 and January, 2009. From his January 18, 2009 New York Times article, “Parsing Gains of Gaza War”:

The Israeli theory of what it tried to do here is summed up in a Hebrew phrase heard across Israel and throughout the military in the past weeks: “baal habayit hishtageya,” or “the boss has lost it.” It evokes the image of a madman who cannot be controlled.

“This phrase means that if our civilians are attacked by you, we are not going to respond in proportion but will use all means we have to cause you such damage that you will think twice in the future,” said Giora Eiland, a former national security adviser.

I would be surprised if any lender had an explicit policy to file irrational foreclosures or seeks deficiency judgments solely as a deterrent to other borrowers. But, modifications are generally the exception and not the rule, and the signal an action sends to other borrowers is always a consideration.