Apr282016

Principal reduction is the worst remedy for the underwater borrower crisis

Principal reduction rewards those who deserve help the least at a very high cost paid by those who obtain no benefit at all.

4.2.7Principal reduction transfers wealth from one party to another. For every underwater borrower who ostensibly needs principal reduction, there’s an investor who holds that loan as an asset; for the borrower to gain, the investor must lose. While few may decry the confiscation of wealth from the one-percenters, most of these loans are held by pension funds for ordinary Americans, and most of those are backed by government loan guarantees, so any widespread principal reduction program would be paid for by everyone, not merely a demonized select few.

Further, costly principal reductions fail to benefit many people who might be worthy of assistance. In fact, most of the benefit would accrue to irresponsible spendthrifts rather than prudent, hard-working Americans. To understand why that is, it’s important to make some important distinctions about the homeowners in need of principal reduction.

First, underwater borrowers own more debt than real estate. In reality, they don’t own their homes at all. Yes, their names may be on title, but if they don’t have any equity, so they don’t own anything. The various proposals for principal reduction only apply to loan owners. No homeowner — a title holder with equity — receives a penny of principal reduction. In fact, true homeowners — those on title with no loan encumbrance — couldn’t receive principal reduction because they don’t have a loan. Principal reductions only benefit title holders with no equity — a benefit paid for by renters (who by definition have no equity) and home owners who really do have equity.

Second, homeowners eligible for principal reduction only need it because they borrowed excessively. If they borrowed responsibly, used fixed-rate financing, and they can afford the payments, then they wouldn’t need principal reduction. Why would they? No lender reduced principal when prices were going up, so why should lenders reduce principal now that prices are lower? Is principal reduction required because unemployed and underwater borrowers need temporary assistance? No, those people obtained (or were offered) loan modifications to weather the economic slowdown, so they don’t need principal reduction.

By and large, the people who supposedly “need” principal reduction over-borrowed, many through rampant HELOC abuse or toxic financing. Most people over-borrowed by choice because they wanted to obtain property they viewed (incorrectly) as a stable investment — property they couldn’t truly afford. After all, if they were only concerned about providing shelter, they would have recognized the savings from renting and chosen not to buy during the bubble. It’s inappropriate for the bureaucrats to confiscate our tax money to bail out real estate speculators and investors.

The only way to fix the housing crisis

Elyse Cherry, CEO of Boston Community Capital, Friday, 22 Apr 2016want_principal_reduction

… It would be welcome news if the Federal Housing Finance Agency (FHFA), which governs Fannie and Freddie, takes this path — cutting the amount a family owes on its mortgage so it no longer reflects an inflated, pre-crash value. But doing so on the very small scale that’s being proposed won’t be enough. If we want to finally recover from the 2008 housing crash — freeing up debt-laden families, helping them stay in their homes and stimulating the economy — the FHFA should enact this initiative as a first step and then expand it.

This is the camel’s nose poking under the tent. Expanding a principal reduction program would be extremely costly, and the benefit would only accrue to a select group of undesirable borrowers, fostering moral hazard.

We know from the government’s own research that large-scale principal reduction works. Three years ago, the nonpartisan Congressional Budget Office (CBO) — the research arm of Congress — found that, had Fannie and Freddie embraced principal reduction after the 2008 crash, they would have foreclosed upon fewer families, saved taxpayer dollars and boosted economic growth. …

Complete and utter bullshit. Obviously, nobody outside the Congressional Budget Office believes the report.

Fannie and Freddie, and the financial sector generally, have so far failed to follow these findings.

principal_forgivenessThat’s correct. The GSEs own analysis reveals the more obvious truth: if the GSEs forgive principal, they will need to forgive every underwater borrower in their entire portfolio, and the losses would be staggering. If the GSEs really believed principal reduction would lose them less money, they would have done so.

Yet principal reduction remains the only path forward from this crisis — for homeowners, the economy, and, in the long run, for banks and other lenders in the financial system.

Actually, no. Lenders can can-kick bad loans, deny short sales, and trap underwater borrowers in their homes until prices come back.

If Fannie and Freddie — which own or guarantee more than half of U.S. residential mortgages — lead on embracing it, other lenders should follow.

Yeah, right. Lenders will abandon their successful can-kicking efforts and embrace massive write downs that bankrupt them as institutions? No way.

In the meantime, let’s be clear: The foreclosure crisis is not over.

(See: Mortgage and foreclosure crisis 2.0)educated_borrowers

If we now know what would work and hasten a full recovery, we also know what hasn’t. As part of the spending package it passed in December, Congress decided with little notice to quietly kill off the Home Affordable Mortgage Program (HAMP). As the only option for many struggling homeowners, it proved ineffective overall. HAMP lowered monthly payments for families, but not by much, and more importantly, it kept intact outsized, pre-crash mortgages that left families buried in debt. Fewer than one million families received assistance from HAMP, and nearly one in three that did use it ended up defaulting again when the loan modifications they received did not go far enough. …

Everyone know HAMP was going to fail from the start, but it quieted the calls from advocates for principal reduction, and it made politicials look like they were doing something about the issue when they really weren’t. (See: Upcoming mortgage resets and recasts prompt more loan modification can-kicking)

FHFA’s proposal to limit the initiative based on mortgage size, among other restrictions, needs to be rethought: It is precisely the bubble-driven, overinflated mortgages that are driving this problem and burying families in debt.

I agree with her that excessive debt is the problem.

When the Great Housing Bubble deflated, everyone incorrectly identified the problem as foreclosure. The real problem was not foreclosure: the real problem is that borrowers carry excessive debts due to the huge loans lenders underwrote and borrowers gladly accepted. Foreclosure is not the problem, it is the cure. Foreclosure purges the excessive debts, and it provides consequences to both lender and borrower to prevent a recurrence of the mania.principal_forgiveness

Principal reductions are the worst possible solution to the problem of excess debt because 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.

If the GSEs reduce mortgage principal, the borrowers avoid the consequences, creating moral hazard. The borrowers who borrowed most foolishly gain the most by principal reduction — and the people paying the price are (1) prudent borrowers and (2) those who didn’t borrow at all. The tenet of moral hazard postulates that everyone will engage in widespread foolish behavior because the consequences for doing so were less than the reward. Who passes on free money? Obviously, nobody does.

We must learn from the mistakes of the past and chart a bold new course. All underwater homeowners, regardless of mortgage size, should be able to access principal reduction, to bring their mortgages in line with the fair market value of their homes. …

I can’t think of a worse course of action.

carrot-principal-reduction

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