(James Saft is a Reuters columnist. The opinions expressed are his own)

If you thought the U.S. housing crash could be blunted if only lenders would cut delinquent borrowers a break, it is perhaps time to move on to another vain hope.

That’s right, the loan modification movement - pushed by the U.S. administration and others as a means of keeping non-paying borrowers in their houses, keeping those same houses from flooding the market as foreclosures, and even helping beleaguered lenders - is running into a reality-shaped wall.

An exhaustive study of loan modifications by economists at the Boston Federal Reserve, under which delinquent borrowers are given lower rates, more time, or even cuts in the principal amount owed, showed fundamental problems with the way that idea works when put into practice.

Looking at data that covers about 60 percent of U.S. mortgages the authors, Manuel Adelino, Kristopher Gerardi, and Paul S. Willen, came up with two important conclusions.

First, securitization, whatever its other shortcomings, is not an important factor in stopping loan servicers from cutting deals with delinquent borrowers.

Second, and even more importantly, lenders don’t renegotiate for a simple, unanswerable reason: it is not in their best interest financially.

Virtually every rescue plan in the U.S. since the crisis began in 2007 has been in part a loan modification program, the most recent being the Making Home Affordable plan the Obama administration unveiled in February.

The thinking is that, as a foreclosure can cost the lender between 30 and 50 percent of the value of the loan, deals can be struck with borrowers for a lot less than that leave everyone better off.

Sadly, very few loans are being modified - only about 3.0 percent of delinquent loans - with many blaming securitization, which can make a loan modification toxic for one class of lender but beneficial for another.

Seeing as how securitization was part of the way finance spun of control and the bubble was inflated, this was a satisfying narrative, but a false one according to the Fed study. They found no significant differences in the rate of renegotiation among loans that were in private-label securitizations and those actually owned by the servicer doing the negotiating with the borrowers.

NEITHER A BORROWER NOR A MODIFIER…

The real issue is that, in the vast majority of instances, banks are better off not modifying.

For one thing, about 30 percent of borrowers who become delinquent get back on track before foreclosure. Since its very hard to know which borrowers will become payers again, this implies that 30 percent of the money expended in modifying loans is wasted, at least from the lenders point of view.

Secondly, a huge percentage of borrowers who are given new improved terms go and become delinquent all over again. A whopping 40 to 50 percent of borrowers who get modified loans are 60 days delinquent again six months later.

For them, and for their banks, it is just delaying the inevitable, and expensive to boot, as falling property prices make putting off foreclosing and liquidating costly.

The implication is that unless the government wants to pony up much larger amounts of money to entice lenders to modify loans, we are not going to make much of a dent in the wave of foreclosures washing across the economy. This could be done, and possibly support house prices in the process, but at a very high costs.

The real issue is that there are too many houses for the supply of credit worthy borrowers. The re-default rate shows that, as does the low clearing price when banks sell foreclosed houses.

Housing needs to fall in value, less of it needs to be built, and more people should become renters. That is going to continue to eat away at bank capital and act as a drag on growth.

Beyond that, there is a real question about the long-term consequences of mass loan modification. If the incentives are there more borrowers will become selectively delinquent and fewer who become delinquent will in the end catch up with their payments. Why should they?

That means higher loan rates than would otherwise be the case.

The thinking behind loan modification has interesting parallels in the rest of the economy, where policy makers are following similar strategies for banks and corporate borrowers.

Rather than simply cutting back on leverage, probably via default, there seems to be a consensus for stringing struggling borrowers, and lenders, along, hoping that something turns up.

Ultimately, it seems likely that strategy is about as successful in the rest of the economy as it seems to be in housing.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

– James Saft is a Reuters columnist. The opinions expressed are his own –

Banks in the U.S. face a new source of write-downs and failures in the coming year as loans made to developers to finance residential and commercial property development rapidly go bad.

And as these loans are old-fashioned and concentrated in smaller banks, their fate is particularly interesting as it indicates that issues with the banking system go far deeper than the so-called “toxic assets” belonging to the largest lenders that have thus far gotten most of the attention and government aid.

They are also a great illustration of the difficulties of stopping a housing and deleveraging crash.

Called Acquisition, Construction and Development (ADC) loans, they total 8.4 percent of all bank loans, just below a 30 year peak, and are used by developers to buy land, put in infrastructure and construct housing or commercial and office space.

And because they are dependent on a reasonably healthy real estate market — someone who is willing to buy or rent the properties — when projects are completed, they are now in deep trouble.

“Everyone in the media is focused on consumer foreclosures. What they’re not focused on is the builder developer foreclosures which are only in the early innings and which will continue to wreck havoc as these assets are liquidated at depressed prices. Until they are cleared there can’t be a stabilization in home prices,” said Ivy Zelman, a longtime housing analyst at Zelman & Associates, who thinks the pressure will cause “hundreds of banks” to be closed and liquidated.

“The Federal Deposit Insurance Corporation doesn’t have the funds to deal with all this. They don’t have the scalability to deal with all these problem banks. They can’t examine the smaller banks fast enough,” she said.

Zelman estimates that U.S. banks risk having to charge off an additional $84 billion of ADC loans between now and 2013, equal to a hit of nine percent of Tier 1 capital.

That is damage banks can ill afford just about now, given the rising trend in delinquencies on consumer and home purchase loans, not to mention a deteriorating outlook for commercial loans.

Non-performing ADC loans hit 8.5 percent at the end of the year, up from just 3.2 percent the year before. Loans delinquent between 30-89 days are also up, by 25 percent in the quarter to 2.9 percent. And developers, struggling to try to survive without reliable cash flow from sales, are drawing down on commitments from banks that are not secured. The percentage of unsecured construction loans drawn down hit 73 percent, above the peak seen during the 1990s real estate slump and a crucial sign of builder distress.

FDIC FUNDING CRUNCH

Of particular concern is the way in which ADC loans are concentrated in smaller and community banks, which tend to have long and deep relationships with local developers. ADC loans account for 47 percent of non-performing loans at small banks as against 14 percent at larger banks.

And you can’t blame mark-to-market or toxic securitizations for these losses. They are considered held-to-maturity and are not typically included in any complex securities.

Chris Whalen of Institutional Risk Analytics, which specializes in bank risk analysis, sees ADC loans as part of the difficulties banks face with commercial real estate, and believes that regulators will be forced to get tough with banks in forcing them to write down exposure to struggling firms and deals.

“It will be subject to an impairment test and than they will have to start charging it off. The regulators are already beginning to force the community banks,” he said.

And while smaller banks being closed by the FDIC may not get the attention of a bailout of a big bank like Citigroup, every failure depletes resources and hurts credit availability.

The FDIC fund fell by almost half in the fourth quarter alone, touching $18.9 billion as it set aside a large portion of money for actual and expected bank failures. The FDIC has said it needs a bigger cushion but moves to impose special fees on healthy banks will inevitably hit profitability and credit availability.

Democratic Senator Christopher Dodd, chairman of the Senate Banking Committee, is moving to introduce legislation that would more than triple — to $100 billion — the FDIC’s line of credit with the Treasury Department.

But even beyond bank failures, ADC loan woes point to the intractable problems of a real estate bust.

Banks, while trying to reduce their overall exposure to these loans, have been reluctant to pull the rugs from under borrowers because, as with a house foreclosure, they end up owning a hard-to-sell underlying asset. But more foreclosures are coming, and with them fire sales as banks compete with those developers who still are in business and with homeowners and with foreclosure sales to liquidate inventory.

That will drive land and real estate prices down further and suck others into what amounts to a negative self-reinforcing cycle.

That’s true for housing, true for banking and true for the economy.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –