A foreclosure settlement plan might make matters worse By Editorial Monday, March 14, 2011; 8:11 PM THE NATION'S mortgage companies have engaged in questionable practices - or worse - regarding loan modifications and foreclosures. Even now the banks have not entirely conquered the scandal that erupted last fall over alleged widespread errors, procedural irregularities and outright misrepresentations - including the notorious "robo-signing" of foreclosure documents. The resulting confusion and controversy forced some banks to halt foreclosures, then start them again, adding a new element of uncertainty to an ailing housing market. The question is what to do about it. At the moment, state attorneys general and some within the Obama administration are pushing for a settlement that would, appropriately enough, force the banks to fix the foreclosure process and streamline loan modifications. More controversially, they are also trying to extract a large cash amount - $20 billion is under discussion - to help write down the principal balances of the 22.5 percent of U.S. homebuyers who owe more than the market value of their homes. There is a certain appeal to the proposal. The government's loan modification efforts to date, though helpful to hundreds of thousands, have fallen short of their most ambitious targets; additional resources might remedy that. Banks are partly responsible, insofar as they failed to invest in the capability to deal with distressed loans. And, compared to the interest-payment adjustments in most loan modifications thus far, principal reductions promise greater and longer-lasting relief to those who get them. Here's the problem - several problems, actually. As flagrant as the mortgage companies' procedural violations might have been, they did not actually cause many foreclosures. John Walsh, the acting Comptroller of the Currency, told a Senate committee last month that federal banking regulators found only a "small number" of people who could have kept their homes but for the banks' misconduct. As Mr. Walsh testified, his agency concluded that "loans subject to foreclosure were, in fact, seriously delinquent, and that servicers had documentation and legal standing to foreclose." Modifications had been tried and failed. Looking back, the $20 billion remedy would have been of no use to these "victims." And looking ahead, it's not clear why anyone who wasn't foreclosed on should get the money. It might help people with negative equity avoid foreclosure - good for borrowers, neighborhoods and even banks, which avoid the hassle and expense of repossessing distressed property. The catch is that, while some borrowers with negative equity are headed for default, some can and will remain current on their loans. No one - not the government, not the banks - can know in advance who will default and who won't. The prospect of qualifying for a principal reduction might induce some borrowers to quit paying, known as "strategic defaulting." Twenty billion dollars' worth of extra mortgage relief is probably too little to make a major impact on the three-quarters of a trillion dollars in negative home equity. but it might be enough to trigger strategic defaulting - and sow frustration and resentment among homeowners who don't get a piece of the action.