Attempts at Relief and Reform

The Idea of Principal Write Downs

Posted on Monday, January 25, 2010

Hate it.

Would principal reductions solve the problem to residential strategic defaults?

Yes. Clearly if borrowers are walking solely because they are upside down and you make it so that they are no longer upside down, they will no longer walk. But this would cause bigger problems than it solve and it inappropriate for other reasons.

Arguments Against Principal Reductions

This is not always (or even most of the time) about the american dream or homeownership of keeping people in homes they deserves. In most cases now it is about keeping people in homes they never shuld have bought in the first place, are staying in by over extending themselves on credit. Reducing principal does nothign to reduce other costs of homeownership: taxes, insurance, even the a/c bill which is much higher in a McMansion with 4 a/c units than in a starter home many borrowers should have bought. WE DO NOT NEED TO SUBSIDIZE LUXURIOUS HOMEOWNERSHIP WITH TAX DOLLARS OR BY MAKING BANKS AND THEIR SHAREHOLDERS TAKE THE HIT. These costs all go up over time, inlcuidng any MHA mod (which goes up in 5 years) so even with a principal reduction we're going to deal with this again. Hasnt anyone even seen a TIL disclosure? The big costs in INTEREST, not principal.

• Forget everyone lost money - $13 trillion – only difference in borrowers lost bank’s money. Only $3.2 trillion of this was on mortgaged properties.

• Not all poor homeowners who cant afford, many have plenty of money. Deutsche Bank report predicted 41% of prime conforming borrowers will be underwater and 46% of prime jumbo borrowers.

Regulators will have to find a new way to deal with this - requriing the usual reserves will mean death to many banks.

• Lenders can and do make best financial decision for them. If best to write down principal, will. They’re in better position to decide than govt or judiciary.

• Nonrecourse loan has been compared to a put option. If put option is priced correctly and passed on to borrower in form of mortgage loan interest rate, these factors have no impact on asset (real estate) price. If priced too, low, it impacts property value. Certain conditions impact banks to underprice the put option/interest rates in order to increase lending volume, especially in good states. This is discovered only when things turn bad. Short terms managers have little incentive to guard against under pricing.

• Lenders tell us that they are reluctant to write down principal. They say that if they were to write down the principal and house prices were to fall further, they could feel pressured to write down principal again. Moreover, were house prices instead to rise subsequently, the lender would not share in the gains. In an environment of falling house prices, however, whether a reduction in the interest rate is preferable to a principal write down is not immediately clear. Both types of modification involve a concession of payments, are susceptible to additional pressures to write down again, and result in the same payments to the lender if the mortgage pays to maturity. The fact that most mortgages terminate before maturity either by prepayment or default may favor an interest rate reduction. However, as I have noted, when the mortgage is "under water," a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure. In my view, we could also reduce preventable foreclosures if investors acting in their own self interests were to permit servicers to write down the mortgage liabilities of borrowers by accepting a short payoff in appropriate circumstances. For example, servicers could accept a principal writedown by an amount at least sufficient to allow the borrower to refinance into a new loan from another source. A writedown that is sufficient to make borrowers eligible for a new loan would remove the downside risk to investors of additional write downs or a re-default. This arrangement might include a feature that allows the original investors to share in any future appreciation, as recently suggested, for example, by the Office of Thrift Supervision. Servicers could also benefit from greater use of short payoffs, as this approach would simplify the calculation of expected losses and eliminate the future costs and risks of retaining the troubled mortgage in the pool. - Chairman Ben S. Bernanke

• The belief that principal write downs somehow solve a problem that other types of modifications can’t is wrong. Overwhelming, loan defaults are caused by income curtailments – the borrower loses a job, households break up, people become ill. Such situations have two characteristics; (1) they are binary, in the sense that a borrower goes from being able to make a full payment to being able to make only a drastically reduced payment, or no payment at all, and (2) they are often temporary. These are the cases where lenders typically offer repayment plans which allow unpaid installments to be repaid over time, with the result that when the forbearance period is over the payments go up. Sometime that works, and when it doesn’t a different form of relief is necessary. But it would be just crazy for a lender to offer a permanent, irreversible principal reduction in these cases.There are really two issues. The first is a classic principal-agent problem; the borrower knows their true financial condition and is in a better position to know the value of the property than the lender. Lenders are understandably reluctant to lock in a loss under these circumstances. The second issue is, who gets the upside if the property is worth more than $200,000 or the value increases later? It’s the borrower with the principal writedown, the lender with the modification. Lenders are reluctant to give up the upside, because debt is supposed to be paid before the equity holder.

• Obama administration decided last month to stand behind unlimited losses that mortgage-finance giants Fannie Mae and Freddie Mac might run up over the next three years. The government had previously pledged to back up to $200 billion in losses at each company. First steps towards principal write downs?

• Moot in nonrecourse states. Even in recourse states lenders rarely pursue borrowers unless know can repay, especially when lenders overwhelmed with cases. Mortgage Debt Relief Act until 2012

Only 1% of all mods involve a principal reduction and thats probably how it shoudl be. In non-recourse states (listed below) the issue is moot in cases where borrowers recongize its time to move on;

Here is a general list of non-recourse states:
California (as long as non-judicial foreclosure is used which is the most common)
ColoradoDistrict of Columbia (Washington DC)
Montana (as long as non-judicial foreclosure is used)
New Hampshire
Texas (but even in a non-judicial foreclosure, the lender can pursue a deficiency judgment)
VirginiaWashington (as long as non-judicial foreclosure is used which is the most common)
West Virginia
These are states that also allow non-judicial foreclosure, and/or where non-judicial foreclosure is more common and deficiency judgments can be obtained more easily:
North Carolina
Rhode Island (lender can seek deficiency judgment)
South Dakota
Utah (lender can seek deficiency judgment)

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