From a long article in the Wall Street Journal on FDIC’s attempts to stave off foreclosures…..

When the Federal Deposit Insurance Corp. seized control of IndyMac Bancorp — the nation’s 10th-largest mortgage lender by loan volume — the agency vowed to ease terms for many of its troubled borrowers. In doing so, the FDIC wanted to show the mortgage industry how it could slash home foreclosures by making decisions both sensible and humane.

That is the goal. Keep that in mind. Now from latter on in the article….

Nanci Puerto, a 40-year-old house cleaner in Antioch, ran into such a problem. She refinanced her house for $637,288 from IndyMac in 2006, taking out cash for a down payment on another property. She and her husband, who works in a machine shop, take home a combined $70,000 a year. Each month, she makes the minimum payment on her loan, $2,416. At the same time, she watches the outstanding principal swell since that payment doesn’t fully cover the interest costs. Now she owes IndyMac $707,000, on a house that the county tax assessor says is only worth $410,000.

When she called the bank, however, she says the agent told her IndyMac is just a “collector” for the investors who own her mortgage. The bank could only consider altering her mortgage terms if she were delinquent.

“I’m going to stop paying so they’ll modify the loan,” Ms. Puerto said this week. “Otherwise they won’t help me.”

There are two things to note. One is that while brining down Ms. Puerto loan down to something that she can afford might make sense, it is still going to involve major losses for the banks that loaned her the money. She is in overhead to such a degree that you are not going to make her house affordable for her with just minor cuts in the monthly payment. You are going to have to offer her a major deal.

But there in lies the rub. If you offer her a major deal, you are going to give everyone else major incentives to game the system so that they qualify for the same deal. Why should should a guy who is just barely making payments get a different deal than Ms. Puerto? Banks can try as hard as they want to try to make sure that those deals only go to people who can’t make their payments otherwise, but human ingenuity will defeat them every time. Nobody is going to pay what they owe once they figure out that banks are terrified of trying to foreclose in this environment.

In short, I understand why people think it is foolish for banks to try to foreclose when they can’t sell the house for anything near what it is worth. But anyone who thinks that loan modifications are going to cut the losses that banks are going to suffer is dreaming. It is not going to work that way.