May172010

Foreclosure Is a Superior Form of Principal Reduction

The banks blew it. We all know that, and now we are all being asked to pay the bills for their catastrophic mistakes. I didn’t cast the first stone, but I hope my writing about this issue has left a lasting impression. I also hope we can all learn something from this are avoid the mistakes again in the future. I have my doubts. We can all see the problem and the solution, but we all know the government is likely to blow it.want_principal_reduction

Excessive debt is the problem

Ever since the Great Housing Bubble began to deflate, everyone has incorrectly identified the problem as foreclosure. The real problem is not foreclosure, the real problem is that borrowers have excessive debts due to the huge loans lenders underwrote that inflated the housing bubble. Foreclosure is not the problem, it is the cure. Further, there is only one reason foreclosure is seen as the problem: people have to move out of their homes after a foreclosure, and I have demonstrated how private hedge funds and other parties could solve that problem.

One way or another, the banks are going to write down huge amounts of bad debt. Nothing can save them, and we shouldn’t try. Principal reductions are the worst possible solution to the problem of excess debt left over from the Great Housing Bubble. Principal reductions merely gives foolish borrowers a pass. If the borrowers go through foreclosure, they have consequences that minimize moral hazard:

  1. Borrowers will be forced to rent, at least for a time.
  2. Borrowers will have reduced access to consumer credit as the foreclosure lowers their FICO score.
  3. Borrowers will have to save and be prudent in order to meet the standards of home ownership and get another loan.

All of those consequences — inadequate though they may be — are eliminated if the GSEs merely reduce principal. The borrowers who have the most to gain are those who borrowed most foolishly, and the people paying the price are (1) prudent borrowers and (2) those who didn’t borrow at all. Next time around, there will be no prudent borrowers, and everyone will participate. Who is going to pass on free money?

The worst part is that the government may decide this is a good idea. If every borrower in the country had their principal balance reduced to the lower of (1) current property values or (2) their ability to repay, prices would stabilize in most markets because the distressed property issues would be eliminated. With the distressed properties eliminated, prices would begin to rise, and HELOC spending could resume again. This would be a huge boom to the economy, and we could begin inflating the next Ponzi scheme. I could see government officials thinking this is a good idea.

Freddie and Fannie won’t pay down your mortgage

By Tami Luhby, May 14, 2010

NEW YORK (CNNMoney.com) — Pressure is mounting on loan servicers and investors to reduce troubled homeowners’ loan balances…but the two largest owners of mortgages aren’t getting the message.

They are getting the message; however, it is a stupid message so they are ignoring it. There is no mounting pressure. What we have is a mounting public relations campaign designed to make it look like there is a possibility of principal reduction. This is a purposeful lie. It is hoped that homeowners will keep paying with the false hope that they might be bailed out. Expect to see this dangling carrot appear periodically over the next several years. Fantasies of principal reduction are the lenders only defense against strategic default.

Fannie Mae and Freddie Mac, which are controlled by the federal government, do not lower the principal on the loans they back, instead opting for interest rate reductions and term extensions when modifying loans.

But their stance is out of synch with the Obama administration, which is seeking to expand the use of principal writedowns. In late March, it announced servicers will be required to consider lowering balances in loan modifications.

And just who would tell Fannie and Freddie to start allowing principal reductions? The Obama administration.

Asked whether they will implement balance reductions, the companies and their regulator declined to comment. The Treasury Department also declined to comment.

The savior Obama is being thwarted by the GSEs and the Treasury Department? Does anyone really believe that? The Secretary of Treasury, Tim Geithner, serves at the pleasure of the president. If Geithner were doing something Obama didn’t approve, Geithner would be fired. The GSEs are totally controlled by the Treasury under the conservatorship agreement. If Obama decided principal reductions at the GSEs was a good idea, he could make it happen. He doesn’t because it would be a catastrophe.

What’s holding them back is the companies’ mandate to conserve their assets and limit their need for taxpayer-funded cash infusions, experts said. If Fannie and Freddie lower homeowners’ loan balances, they are locking in losses because they have to write down the value of those mortgages. Essentially, that means using tax dollars to pay people’s mortgages.

That seems like a pretty good reason not to give principal reductions. Do taxpayers really want to directly gift people hundreds of thousands of dollars in debt relief? What are we getting out of it? What lessons will these people learn? Obama knows that principal reduction is a very costly solution that creates a transfer of wealth from the taxpayers to homeowners. The gross unfairness of such a transfer and the moral hazard it would create is a very good reason not to do it.

The housing crisis has already wreaked havoc on the pair’s balance sheets. Between them, they have received $127 billion — and recently requested another $19 billion — from the Treasury Department since they were placed into conservatorship in September 2008, at the height of the financial crisis.

Housing experts, however, say it’s time for Fannie and Freddie to start reducing principal. Treasury and the companies have already set aside $75 billion for foreclosure prevention, which can be spent on interest-rate reductions or principal write downs.

“Treasury has to bite the bullet and get Fannie and Freddie to participate,” said Alan White, a law professor at Valparaiso University. “It’s all Treasury money one way or the other.”

Though servicers are loathe to lower loan balances, a growing chorus of experts and advocates say it’s the best way to stem the foreclosure crisis. Homeowners are more likely to walk away if they owe far more than the home is worth, regardless of whether the monthly payment is affordable. Nearly one in four borrowers in the U.S. are currently underwater.

Notice the repeated nonsense about expert opinions. The reporter is promoting the idea that there is consensus among experts that principal should be reduced. That is not reality. The consensus among experts is that principal reduction is a bad idea because principal reduction is a bad idea. The “growing chorus” is a group of crazies assembled to promulgate the purposeful lie to get people to hang on and make a few more payments.

“Principal reduction in the long run will lower the risk of redefault,” said Vishwanath Tirupattur, a Morgan Stanley managing director and co-author of the firm’s monthly report on the U.S. housing market. “It’s the right thing to do.”

This is a specious argument. Reducing principal to lower risk of redefault? While they are at it, why don’t they forgive all mortgage debt? If people had no mortgage at all, defaults would certainly decline. This idea is like saying we should give money to theives so they don’t steal from us.

If the mortgage balance is reduced through a foreclosure — which is how the system is designed to work — then there are consequences to the borrower. The government or private entities can work to improve the lives of former owners and even allow them to stay in their homes, but they must endure the consequences of (1) renting for a few years, (2) living without new consumer debt, and (3) saving to be able to purchase a home again. If their principal is reduced by the GSEs, none of these meaningful consequences will impact borrowers.

Meanwhile, a growing number of loans backed by Fannie and Freddie are falling into default. Their delinquency rates are rising even faster than those of subprime mortgages as the weak economy takes its toll on more credit-worthy homeowners. Fannie’s default rate jumped to 5.47% at the end of March, up from 3.15% a year earlier, while Freddie’s rose to 4.13%, up from 2.41%.

On top of that, the redefault rates on their modified loans are far worse than on those held by banks, according to federal regulators.

Some 59.5% of Fannie’s loans and 57.3% of Freddie’s loans were in default a year after modification, compared to 40% of bank-portfolio mortgages, according to a joint report from the Office of Thrift Supervision and Office of the Comptroller of the Currency. This is part because banks are reducing the principal on their own loans, experts said.

So, advocates argue, lowering loan balances now can actually save the companies — and taxpayers — money later.

What? The GSEs will lose money on their portfolios whether through principal reduction or through foreclosure. They will lose less if they go through foreclosure because fewer loans will go bad. If they forgive principal, they will need to forgive everyone in their entire portfolio. How could they selectively forgive principal and achieve fairness to all borrowers? Do we forgive principal for HELOC abusers? They really need it.

What message does principal forgiveness send to those who were foolishly prudent? Think about it: if you were prudent and paid down your mortgage, you will probably not see much if any principal reduction; however, if you were a wildly irresponsible HELOC abuser, you will see significant principal reduction which will merely enable more HELOC abuse later. Principal reductions will serve as a major incentive for reckless borrowing. Everyone knows if enough people take the money and behave stupidly that everyone will get bailed out.

Foreclosure balances the equation. There must be some consequences to borrowers for their behavior, not because it is immoral, but because what you don’t punish, you encourage. We can’t afford to privatize gains and collectivize losses or we will go broke as a country. We are not a banana republic, but principal reduction without consequence is certainly a path that leads us there.