Friday, January 8, 2010

Principal Cuts on Lender Menus as Foreclosures Rise

Original posted on Bloomberg by John Gittelsohn and Prashant Gopal

Efforts by U.S. banks to help distressed homeowners have focused mainly on temporary fixes such as interest-rate reductions that may only put off the day of reckoning, despite policy makers wanting them to do more.

Banks may be forced to resort to a remedy they’ve been trying to avoid -- principal reductions -- as another wave of foreclosures looms and payments on risky loans rise, Bloomberg BusinessWeek magazine reports in the Jan. 18 issue.

While interest-rate reductions or extending loan terms reduce homeowners’ monthly payments, they don’t give much comfort to borrowers who owe more on their homes than their properties are worth. Borrowers who don’t have equity in their homes are more likely to hand over the keys when they run into trouble. “The evidence is irrefutable,” Laurie Goodman, senior managing director of Amherst Securities Group in New York, testified before the U.S. House Financial Services Committee on Dec. 8. “Negative equity is the most important predictor of default.”

The 25 percent plunge in residential real estate prices from their 2006 peak has left homeowners underwater by $745 billion, according to research firm First American CoreLogic --a number that tops the government’s $700 billion bailout for banks. That’s why Federal Deposit Insurance Corp. Chairman Sheila Bair is considering incentives for lenders to cut the principal on as much as $45 billion of mortgages acquired from seized banks. “We’re looking now at whether we should provide some further loss-sharing for principal writedowns,” says Bair. “Now you’re in a situation where even the good mortgages are going bad because people are losing their jobs.”

Deepening Crisis

The foreclosure crisis is likely to deepen this year in part because payments on many adjustable-rate mortgages are set to balloon. Unless there’s a sharp recovery in property values or a change in lenders’ willingness to cut principal, at least 7 million borrowers currently behind on their payments will lose their homes, Goodman estimates.

Some lenders may be coming around to the idea of principal reduction. “If you can right-size the mortgage and return to an equity situation, the incentive is to stay,” says Micah Green, an attorney at Patton Boggs in Washington and a lobbyist for a coalition of mortgage bond investors. Banks can either forgive principal outright or defer it. In deferrals the borrower must pay back the full amount on the original mortgage when he sells the property; if the ultimate sales price doesn’t cover the principal, the homeowner has to pay the difference, making it a less effective tool.

Deferring Principal

A principal deferral helped Marcus Beckett stave off foreclosure. The 42-year-old small-business owner couldn’t afford his $2,413 monthly mortgage bill after his income dropped and his son, Riley, was born. In October, OneWest Bank agreed to defer $66,000 of the $423,000 debt on his two-bedroom condominium, which he’ll have to pay back if he sells his Aliso Viejo, California, home. The monthly tab on the house he bought in 2006 is now $1,314. “It’s like I got a second chance on life,” Beckett says. “I feel, mentally, I’m able to keep making payments.”

While principal reductions remain rare, banks are doing them more often. In the third quarter of 2009, some 21,000 home loans -- 3 percent of the total modified mortgages -- included a principal reduction or deferral, according to Mortgage Metrics, a government publication. That’s up from 6,245 in the first quarter of 2009, the first time the U.S. reported the data.

Positive Results

Banks that negotiate principal reductions have seen positive results. Principal forgiveness can be more than twice as effective in slowing re-defaults than reducing an interest rate, according to a December study by the Federal Reserve Bank of New York. Cutting a homeowner’s principal would be especially powerful in Florida, Nevada and Arizona, markets likely years away from recovery, said Joseph Tracy, executive vice president of the New York Fed and coauthor of the study.

“Lenders are going to eat the losses at some point in time,” Tracy said. “There’s a real chance to recognize the loss by forgiving principal today instead of waiting.”

Last year, Wells Fargo & Co. cut $2 billion of principal on delinquent loans. After the modifications, the six-month re- default rate on those loans was roughly 15 percent to 20 percent. That’s less than half the industry average. “We are very comfortable with what we’ve been doing,” says Franklin Codel, chief financial officer of the bank’s home-lending unit. “We offer a principal reduction if that makes sense for that individual borrower’s situation.”

Option ARMs

When principal reductions were granted for pay-option adjustable-rate mortgages -- loans with high default rates because they enabled borrowers to pay less than the cost of interest as the principal increased -- the re-default rate after 60 days fell to 6 percent, according to Mortgage Metrics.

“In terms of incentive, you have more skin in the game or less negative equity to deal with,” said Fred Phillips-Patrick, director of credit policy for the Office of Thrift Supervision.

Many banks don’t want word to get around that they reduce principal. They fear that homeowners who can afford their payments will demand better deals. John Lashley, a 44-year-old salesman in Huntersville, North Carolina, is making his payments. But he is thinking about walking away from his four- bedroom home unless his lender, Sun Trust Mortgage, agrees to cut the principal on his $345,000 loan.

The house next door recently sold for $260,000, and Lashley doesn’t see the point of pouring money into his house when he may never recoup the investment he made in 2007. “Why should I stay in my house?” he says. “It’s not a moral decision. It’s a financial decision.”

Dueling Interests

The conflicting interests of mortgage lenders and home- equity lenders is a roadblock to doing principal reductions. Banks, credit unions and thrifts held $951.6 billion in home- equity loans as of Sept. 30, according to Federal Reserve data.

Mortgage lenders don’t want to cut principal unless the home-equity lenders agree to take a hit. Typically, though, the home-equity lenders are reluctant; much of the value of their loans would be wiped out. That could drive more banks into insolvency, says Joshua Rosner, an analyst at investment research firm Graham Fisher in New York.

The threat of lawsuits is also hampering principal reductions. In December 2008 money manager Greenwich Financial Services sued lender Countrywide Financial in New York State Supreme Court. Greenwich, which owns mortgage-backed securities, demanded 100 cents on the dollar for some Countrywide investments. The securities included loans on which Countrywide had agreed to cut $8.4 billion in principal and interest to settle allegations of predatory lending.

Legal Hurdle

Greenwich Financial’s case is pending. Bank of America Corp., which bought Countrywide in 2008, says: “We are confident any attempt to stop this program will be legally unsupportable.” Greenwich says it’s willing to accept loan changes that benefit borrowers.

So far the feds haven’t put pressure on banks to forgive debt. President Barack Obama’s $75 billion program to spur banks to alter loan terms doesn’t require them to do so. But the FDIC and other regulators are looking at measures to promote the writedowns. Mark Zandi, the chief economist for Moody’s, who has testified before Congress on housing issues, proposes that banks receive a federal match of $1 for every $2 in principal reductions they offer to homeowners who were victims of predatory lending practices. “You’re not going to wipe out all the borrowers’ negative equity,” he says. “This just gives them enough hope to get them committed again.”


  1. I can't believe banks would rather push homes into foreclosure than work on a prinicpal reduction. It's clear at this point that mortgage modifications are not working. Even the latest modifications are redefaulting at rates that make the worst subprimes look like good investments.

    But since the banks seem unwilling (for whatever reason) to reduce principal and actually lower foreclosures, it's time for the administration to step up. The current program pays banks for any modification -- even those that increase principal and payments. The program should only subsidize principal foregiveness.

    Just my two cents. Thanks for the great blog.

  2. the banks better move fast for the shit is about the hit the fan


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