Perry, the banks absolutely can do this if they so choose. It’s no violation of underwriting standards or banking regulations. BUT, they have to charge off that $125K immediately and that’s a direct hit to the bank’s equity (depending on the size of the bank’s reserve). Essentially the bank is saying, “We made a mistake on the first loan and are charging off the size of our ‘mistake’ and now the homeowner’s debt/income, etc. makes sense so we have a new, properly underwritten loan.” Enough of these ‘mistakes,’ however, and the bank has no equity left. Recall that the average bank balance sheet is leveraged 12.5-to-1, so if the assets are worth 1% less than initially believed, equity takes an 8% hit. The problem in the larger context is that most home loans aren’t on bank or thrift balance sheets – they’re securitized into pools owned by investors (in the form of MBS) and serviced by Wall Street-affiliated firms. The question is whether the owners of these MBS will allow the servicers of these MBS to engage in the same kind of loss mitigating behavior. Possible, but I doubt it. When a bank (or thrift) owns a loan there’s just two parties involved, the bank and the borrower. So, it’s pretty easy to work out a deal if there’s one to be made. Once a loan is part of a securitized pool, however, it gets very complicated to efficiently fix a problem because there are more parties involved. What’s best for the servicer might be in conflict with what’s best for the MBS holder which might be in conflict with what’s best for the owner, etc.
