Principal reductions fail to reduce future default rates

Principal forgiveness is the worst policy option. Despite this fact, it’s so appealing to loan owners and politicians, reporters are keen to write about the prospect. However, the world is not comprised only of loan owners. Nearly 40% of households are renters, and of the remaining 60% who own homes, 90% of them are still paying their mortgages. Ninety-four percent of the population is asked to fix the problems of the 6% who are loan owners and the banksters who created the problem.

Lenders and loan owners have problems. Lenders made loans their borrowers can’t repay, and now both parties to the deal are turning to the US taxpayer for a bailout. Somehow, these two groups have convinced themselves they deserve some of my money. I was not a participant in their transaction. I did not sign on to the risks and rewards of the deal they made, yet both groups feel I should be compelled to bail them out. Screw them both. Their problem is not my problem.

There is a problem here: excessive debt. There is also a solution in the system: foreclosure and bankruptcy. Both parties to this private financial transaction want to avoid the consequences of foreclosure and bankruptcy because it will cost banks their money and borrowers their houses and their credit. Moral hazard dictates both parties should endure the consequences of their actions or they will repeat their mistakes.

Many reports in the mainstream media portray principal forgiveness as a good idea resisted by the evil banksters. It has a certain populist appeal, and the banksters deserve much of the ill will they receive. However, on this issue lenders are resisting principal forgiveness because it is a spectacularly bad idea.

Credit Suisse Says Mortgage Principal Cuts Don’t Help Homeowners

January 20, 2012, 5:50 PM EST — By Jody Shenn

Jan. 20 (Bloomberg) — Reducing mortgage balances is a risky idea that hasn’t been shown to keep borrowers who owe more than their property’s worth in their homes, according to Credit Suisse Group AG.

Of the 11 million of “underwater” homeowners, about 6.5 million have never missed a payment and 2 million more are making on-time payments after a delinquency, said Dale Westhoff, the bank’s global head of structured products research.

Let’s pause for a moment and contemplate those numbers. If only 6.5 million out of 11 million underwater loan owners have not missed a payment, then 4.5 million have. That means 41% of underwater loan owners are or have been delinquent on their mortgage. Wow! That deserves its own headline.

Widespread principal reductions may drive defaults “much, much higher” as borrowers seek the aid, he said.

If default is prerequisite to getting free money, then the remaining 6.5 million borrowers will default. Why wouldn’t they? They are already have no equity. What do they really have to lose?

“We’ve never done this before; we don’t know what the risk is,” Westhoff, a top-ranked mortgage-bond analyst in polls by Institutional Investor magazine for 15 years in a row while at Bear Stearns Cos., said today at a briefing for reporters in New York. Along with creating so-called moral hazard, the step may also tighten lending by forcing banks to offer “price protection” to borrowers, he said.

Whenever I see the term “so-called” when referring to something like moral hazard, I wonder if the reporter is implying the label is inappropriate. Read the sentence above and see if the term “so-called” could be removed without any loss of meaning or understanding.

Principal reduction would create moral hazard on steroids. Borrowers already are prone to be irresponsible with debt, if they knew they couldn’t lose their homes and they might receive principal forgiveness if things go wrong, there is no incentive at all to be the slightest bit prudent. Worse yet, the American taxpayer is the one being asked to pay the bills. Why not just announce a government grant program to anyone who wants a house? That’s what they are really doing.

Credit Suisse’s view puts it at odds with Federal Reserve Bank of New York President William C. Dudley; Amherst Securities Group LP analyst Laurie Goodman, a member of the Fixed Income Analysts Society’s Hall of Fame; and hedge-fund manager Greg Lippmann, who last year advocated principal reductions, citing data from his former employer, Deutsche Bank AG.

The reporter’s bias is clearing showing now. Look at the list of fools above who advocate some form of principal reduction. The reporter is making it look as if there is a consensus on the issue. There is not. The policy consensus is clear: principal reductions are not going to happen.

Debt Forgiveness

Dudley said this month policy makers should consider allowing non-delinquent borrowers to earn debt forgiveness with on-time payments, while state attorneys general and federal regulators may encourage principal reductions as part of a settlement being negotiated with the biggest banks over their foreclosure practices.

There is already debt forgiveness with on-time payments. It’s called loan amortization. If lenders want to apply more toward amortization, they can reduce the interest rate on the loan.

Data Credit Suisse examined show essentially no difference in re-default rates among delinquent borrowers given only payment reductions and those also offered smaller mortgages, Chandrajit Bhattacharya, an analyst at the bank, said at the briefing.

Half way through the article, and we finally get to the key piece of information. The analysts prove there is no statistical improvement in re-default rates. The only reason lenders consider principal reduction is because they believe they will get a few more payments out of the borrower. If it turns out borrowers default anyway, then lenders have no incentive to reduce principal. This is a huge finding, and it will be a death blow to voluntary efforts from banks to reduce principal. Lenders may get forced into it, but with no advantage in repayment, they won’t forgive principal voluntarily. Why would they?

Based on loans in mortgage bonds without government backing, about 40 percent of borrowers whose payments were cut between 20 percent and 40 percent defaulted again after 12 months, regardless of whether they were more than 60 percent underwater or had home equity between zero and 20 percent, according to Credit Suisse.

Data from bank regulators also show almost no difference in re-defaults among loans in the portfolios of banks, whose modifications include principal cuts 18 percent of the time, and mortgages guaranteed by government-supported Fannie Mae and Freddie Mac, which don’t lower balances, Bhattacharya said.

How much more clear does the data need to be? Refault rates do not improve with principal reduction. When lenders write down principal, they give up the upside and take a hit on their balance sheets, and they don’t obtain any tangible benefit. They won’t continue to try if this data is verified.

Resisting Calls

“You’ve got to base policy on something that’s factual,” he said. “You can’t base policy on something that you expect that hasn’t happened yet.”

Fannie Mae and Freddie Mac, the mortgage firms overseen by Federal Housing Finance Agency Acting Director Edward DeMarco, and lenders including Bank of America Corp. have resisted calls for widespread reductions of mortgage balances, saying the move is unnecessary or may encourage more homeowners to default.

The New York Fed’s Dudley said Jan. 6 that “analysis by my staff that looks at likely borrower behavior over an extended time horizon suggests that without a significant turnaround in home prices and employment, a substantial proportion of those loans that are deeply underwater will ultimately default — absent an earned principal reduction program.”

This data proves Dudley is wrong. Even with a principal reduction program, loan owners are going to default. The only remaining question is whether or not they default earlier or later. If lenders can obtain a few more payments, then they may try principal reductions to kick the can down the road and squeeze a few more pennies out of borrowers who will default anyway.

Amherst’s Goodman says that principal reductions are needed to avoid 8 million to 10 million more distressed-property sales. …

Principal reductions will not avoid the distressed property sales. This new data proves that. If these borrowers re-default anyway, then the sales are not avoided. Goodman is wrong.

–Editors: John Parry, Dennis Fitzgerald
To contact the reporters on this story: Jody Shenn in New York at [email protected];
To contact the editor responsible for this story: Alan Goldstein at [email protected]