Magazine article Mortgage Banking

Principal Reductions: Will He or Won't He?

Magazine article Mortgage Banking

Principal Reductions: Will He or Won't He?

Article excerpt

It is an unfortunate fact that the insatiable demand for residential mortgage securitizations allowed millions of borrowers with no income or assets to obtain mortgages, especially toward the end of the boom when house prices were at unprecedented heights. In retrospect, it should have been obvious that because what goes up must eventually come down, there would be hell to pay when the trajectory reversed and the house of cards collapsed.

In retrospect, we should have seen that the economy would crumble when foreclosures became epidemic, that investors would then abandon the market and that by calling in their chips, they would cause the failure of systemically important financial institutions and a global liquidity crisis. It is beyond unfortunate that we had no contingency plans for what to do when it did.

The sad facts are these: Millions of borrowers have lost their homes to foreclosure. Millions more are in default but have not yet been fore closed.

The collapse of the market has, according to the Federal Reserve, destroyed $7 trillion in housing wealth and has left additional millions at risk of default, in part because their homes are worth less than what is owed on the mortgage.

Each new foreclosure causes additional negative price pressure, and the foreclosure rate is expected to increase by as much as 25 percent this year now that the $25 billion foreclosure abuse settlement has given lenders and servicers a clear roadmap. Since there is no question that economic recovery won't start until house prices stabilize, and that the enormous backlog of defaulted borrowers will delay that recovery and cause further damage if they are foreclosed, Washington is intensely focused on how best to stem the tide.

There is no shortage of ideas. Under the federal Making Home Affordable programs, distressed borrowers have options that include the Home Affordable Refinance Program (HARP), the Home Affordable Modification Program (RAMP) and the Home Affordable Foreclosure Alternative (HAFA) program. Lenders and servicers also offer proprietary programs that include the same remedies, as well as forbearance and--although not widely used and definitely not widely advertised principal reductions.

At first glance, principal reductions seem to be a no brainer solution to the problem--if borrowers can't afford their mortgage payments, reducing their debt has the potential to decrease the probability of default by improving a household's financial position and thus increasing its resilience to economic shocks. Principal reductions would also reduce the deadweight costs and negative impacts of foreclosure on the economy, and reduce the incentive to engage in "strategic" default (that is, a default due solely to the negative equity rather than the afford ability of the payments).

Opponents counter that it is difficult to estimate the effect of reducing negative equity on default because borrowers with high loan to value (LTV) ratios tend to have other characteristics correlated with default. For example, high LTV home owners often made small initial down payments--often due to a lack of financial resources--and tend to live in areas with greater declines in house prices, where unemployment and other economic conditions also tend to be relatively worse.

Opponents also note that the costs of large-scale principal reduction would be substantial because there are an estimated 12 million mortgages that are underwater, with aggregate negative equity of $700 billion. While the cost could be reduced by targeting borrowers who are already in default or at higher risk of default, this approach raises fairness issues to the extent that it discriminates against those who were more conservative in their borrowing for home purchases, and it could give borrowers who otherwise would not have defaulted an incentive to do so. The latter is a serious concern, given that about 8.6 million mortgages, representing roughly $425 billion in negative equity, are current on their payments; almost 3 million of these are guaranteed by government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. …

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