Basing mortgage modifications completely on income is a bad idea.

I have said all along that the foreclosure prevention plan was the least effective part of Obama's 3 part economic strategy: Stimulus, bank bailout, mortgage modifications.

Loan modifications in this plan are completely determined by income, and making the payment "affordable." This distorts incentives, rewards lying, is unfair in several ways, and does nothing to reduce underwater mortgages (the biggest cause of foreclosures). The cost to live in a house should be connected to the underlying value of the house, it shouldn't be income based like college financial aid.

I prefer mortgage modifications focus on principal reduction, preferably under a shared appreciation set-up so that the party that finances the principal reduction (whether lender or govt. subsidy or some combination) is at least partially repaid if the home is sold in the future. Principal reduction will likely be more expensive or require some heavy handed govt. action on lenders. However, it also will be much more effective preventing foreclosures (thereby improving social welfare) and more fair. Income verification matters for these modifications, but at the end of the process to determine whether you can afford the house/loan as it does for regular mortgages.

There were proposals for this kind of plan last fall, but the administration went with the income approach. Now that it isn't working that well, it isn't too late to try something new. The foreclosure problem isn't going away anytime soon.

A good article in the New York Times highlights some of the issues. Some clips below, but I recommend the whole article.

The banks, and the government, are soon going to have to decide what to do about borrowers who are making the modified payments but have not provided the documents (to prove their income) after repeated efforts to obtain them. Should the banks just take the money and let the preliminary modification turn permanent? Or should they foreclose?Those decisions will affect just how fair the program is seen to be. If the banks allow those who do not submit documents to get by without doing so, it will appear unfair to those who told the truth about their income, and paid more than they might otherwise have been required to pay. If they do not, the wave of foreclosures could devastate more neighborhoods.
The rules now being applied, in some cases clumsily, had a Goldilocks quality; to get a modification a borrower had to need it a lot, but not too much. If the home was “underwater” — worth less than the balance of the loan securing it — but the borrower could still afford the payments, there was to be no modification. If the borrower was in such bad straits that default was likely even with a modification, again that borrower was supposed to be turned down.