Saturday, March 27, 2010

Foreclosure or forgiveness?

Absent a thorough review of HAMP and its goals, the program risks helping few, and for the rest, merely spreading out the foreclosure crisis over the course of several years…

- Neil Barofsky, Sigtarp, Congressional Testimony

Surprised? You shouldn’t be, because as Sigtarp have previously said, this is exactly what the government is aiming for; re-inflating house prices by preventing a wave of foreclosures.

The US government is now looking at altering the centrepiece of its anti-foreclosure plans, the Home Affordable Modification Program. Where the Hamp aims to keep homeowners in their houses mainly by reducing interest payments, the new scheme will be focused on principal forgiveness.

Principal reduction is probably less prone to redefaults, but it’s something which banks have traditionally been very reluctant to offer for a number of reasons.

But Bank of America made a big principal reduction commitment on Wednesday, announcing a programme as part of a settlement with Massachusetts state.

So which is better, foreclosure or forgiveness?

Barry Ritholtz at the Big Picture and Rortybomb’s Mike Konczal, are erring towards the foreclosure side. The argument being that foreclosures generate economic activity and allow people to move into residences they can actually afford. Deleveraging is what the system needs, and all that.

(Significant) questions of moral hazard aside, which would be worse for the banks, mass principal forgiveness or mass foreclosures? Both would involve some losses — but which would be higher?

BofA’s programme, which is aimed only at certain classes of mortgages, will result in a principal decrease of $3bn — with the foregone amount possibly recognised as a loss upfront. That’s no small number given that the Bank’s loan loss reserves on its mortgage book are about $4.6bn.

But look at this chart from Barclays Capital. ‘Real-estate owned’ is what’s known as shadow housing inventory, or the properties owned by banks and mortgage companies:

And this is where the benefit of Hamp, for banks, comes in.

Even as foreclosures have continued to rise, the REO-category has for the most part fallen. As Barclays have previously put it, the time between the borrower going delinquent and the house actually hitting the market has been delayed. That eases pressure on house prices, and on banks’ books as well.

What we’re lacking here is an estimate of how painful a rise in REO-owned properties would be for banks. Would it, in the case of BofA, for instance, be more than the $3bn in principal reduction?

That’s the big question here, and one we’ve found few answers to so far.

Here, for what it’s worth, is what Barclays Capital says:

The U.S. banking industry has $1.5 trillion of residential mortgages on balance sheet and another $0.6 billion of home equity. While principal mods have proven to have lower re-default rates than traditional mods, principal forgiveness or forbearance could result in an increase in net charge-offs. We also worry that this could lead to more moral hazard. Furthermore, to the extent it is spreading out the foreclosure issues, it could take longer for normalized earnings to be achieved (see shadow inventory). Still, in some instances, the cost of foreclosures could exceed the expected reduction in principal.

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