Loan modifications and principal reductions fail to prevent future delinquency

In early 2010, i predicted the moral trepidation about strategic default would largely be gone from the American psyche. People are beginning to look at their homes as their other investments, and when the numbers favor waling away, they do so. People are opting to get out of the rat trap of working to service a bottomless pit of debt.screw_yourself

As underwater borrowers strategically default, lenders are trying different methods for holding back the rising tide. Loan modifications have postponed some foreclosures, and principal reductions might postpone a few more. The value in doing a few principal reductions goes beyond the money spent. It makes for a fantastic carrot lenders can dangle in front of distressed borrowers. Lenders benefit if the herd makes a few more payments based on false hope — whether that false hope be imminent appreciation or potential debt relief, lenders don’t care. They just want a few more payments.

The article you are about to read touts the success of principal reductions and attempts to persuade the reader principal reductions are a viable alternative. In reality, principal reductions do little to sustain home ownership. The only real benefit is that banks may get a few additional, albeit reduced payments from some borrowers.

Mortgage Servicers Resist But Cut Debts

By RUTH SIMON And NICK TIMIRAOS — March 28, 2011

U.S. banks are resisting efforts by state attorneys general to force them to cut the amounts owed by some borrowers facing foreclosure. Yet mortgage companies already have reduced home-loan balances for more than 100,000 borrowers.

In for a penny, in for a pound? Who cares if they tried some principal reductions? They tried some, found out it didn’t help, so now they don’t want to do more of them.

How much larger the number will grow is likely to be at the center of negotiations this week aimed at reaching a settlement to the nationwide investigation of mortgage-servicing practices.

Officials from Bank of America Corp., J.P. Morgan Chase & Co., Wells Fargo & Co., Citigroup Inc. and Ally Financial Inc.’s GMAC unit have been summoned to Washington for a Wednesday meeting with state attorneys general and at least three U.S. agencies, according to people familiar with the situation.

It will be the first faceoff since the five companies, the largest home-loan servicers in the U.S., got a 27-page “term sheet” earlier this month from state attorneys general that would require the servicers to consider more borrowers for principal write-downs.

What does it mean to “consider” someone for a principal write down? Won’t the banks “consider” each borrower for principal reduction, say no, then foreclose on them? Are the AGs suggesting a specific change to lender guidelines?

In addition, some of the financial penalties resulting from any settlement are “very likely” to be used for reductions in loan balances for certain borrowers, said Iowa Attorney General Tom Miller, who is spearheading the 50-state investigation.

Statements like his merely feed into the false hope of distressed borrowers everywhere. Principal reductions will only occur on the mortgages deepest under water in a belated attempt to keep the hopeless paying a little longer.

Even among state officials, there are disagreements as to whether shrinking loan balances is a good idea.

There’s debate about the idea of principal reductions because it’s a really bad idea. Foreclosure is a superior form of principal reduction.

The “term sheet’s principal reduction proposals may actually foster an unintended ‘moral hazard’ that rewards those who simply choose not to pay their mortgage,” the Florida, South Carolina, Texas and Virginia attorney generals wrote in a March 22 letter to Mr. Miller.

At least of few of these guys get the implications of their pandering.

The chief executives of Bank of America and Wells Fargo have questioned the fairness of writing down loans, while claiming the costs could be enormous if widespread principal reductions are triggered by a settlement.

Speculation that “we want everybody ‘underwater’ to receive a principal reduction is not true,” Mr. Miller said in an interview, though lopping off thousands of dollars from what a borrower owes on a mortgage “has been underutilized as a tool.” An underwater borrower is one who owes more on a property than it is worth.

They may not want everyone to get a principal reduction, but they do want to create the false impression that everyone might get one. Principal reduction has not been underutilized as a tool to cure mortgage default. It doesn’t work. Chainsaws are underutilized tools in operating rooms, and I hope it stays that way.

This month’s proposal by state attorneys general would require banks to reduce loan balances for some borrowers if a modification that includes a principal reduction would provide a better long-term return than foreclosure or a loan modification that simply cuts the borrower’s interest rate or extends the loan’s life.

Based on the statistics, there is little or no difference in redefault rates between those who received principal reduction and those who only obtained a modification. How could anyone establish that principal reductions are better when the data clearly shows they aren’t?

Loan balances would be trimmed over a three-year period, but only if borrowers made steady payments.

Bailouts and false hopes. String people along for three more years and pray the market has moved higher. It merely delays the inevitable.

Some loan servicers under investigation by state and federal officials already are slicing loan balances on a very narrow basis. In 2009 and 2010, Wells Fargo forgave a total of $3.8 billion in principal—or an average of $51,000 per loan—for roughly 73,000 borrowers whose mortgages are owned by the San Francisco bank.

There are 11,000,000 underwater loan owners. The 73,000 loan owners Wells Fargo gave money to represent 0.66% of the total.

Bank of America, based in Charlotte, N.C., had offered loan modifications to more than 127,000 borrowers as of December as part of its previous settlement with state attorneys general over alleged predatory lending by Countrywide Financial Corp., which it bought in 2008. An estimated 35,000 of those offers included a principal reduction.Officials at Bank of America and Wells Fargo said the two banks are comfortable reducing loan balances for certain borrowers, but oppose broad-based cuts. One reason: Some borrowers could stop making payments to get their debt reduced.

A recent study by Columbia University economists concluded that Countrywide’s relative delinquency rate “increased substantially…during the months immediately after the public announcement” of the 2008 settlement.

Banks have empirical proof of their own common sense. If you give people incentive to quit paying their mortgage to obtain a principal reduction, many borrowers will default.

“It’s certainly something to be worried about, but you can’t point to this and say, ‘Well, we can’t do any modifications,’ ” said Christopher J. Mayer, one of the study’s authors.

Why not? Why do we have to do loan modifications or principal reductions? People are scurrying about in Washington trying to solve a problem they made up in their own minds — a problem that will solve itself if they let the process go forward and foreclose on the delinquent mortgage squatters.

Most loan-modification programs have focused on temporarily reducing interest rates and extending loan terms.

Principal reductions have gotten more attention recently because so many borrowers owe more than their homes are worth.

At the end of 2010, nearly 11.1 million borrowers, or nearly 23.1% of those with mortgages, were underwater, according to CoreLogic Inc. The tepid nature of the housing recovery suggests many borrowers could remain underwater for years.

There isn’t much hope for appreciation bailing this group out. With that many distressed owners, enough of them are going to succumb to their own debts that a steady supply of distressed properties will stop any real appreciation.

Supporters of principal reduction say borrowers who receive such cuts are less likely to redefault.

“Principal write-downs are much more likely to create a loan that is sustainable over the long-term,” said Massachusetts Attorney General Martha Coakley, who has made principal reductions a component of four predatory lending settlements.

A study last year by the Federal Reserve Bank of New York found that loan modifications with principal reductions are far more likely to succeed than those that simply reduce interest rates.

According to mortgage servicer Ocwen Financial Corp., 17% of its borrowers who got a principal reduction were behind on their payments again six months later, compared with 20% of those with a modification that reduced payments but not the loan balance.

The data clearly does NOT support the contention that principal reduction sustains home ownership. If 12 months later the difference in redefault rates is so small as to be negligible. No matter what you do with the over-indebted short of foreclosure and bankruptcy is going to save their homes. It isn’t just the first mortgage debt that is weighing these borrowers down. They often have huge second mortgages or HELOCs, large credit card debts, and car payments.


Over the past year, Ocwen has cut balances on more than 16,000 loans, representing 22% of its modifications.

“We found that it’s essential to include principal reduction in our modification arsenal to be able to address the negative equity problem,” said Paul Koches, Ocwen executive vice president. In February, Ocwen rolled out a program that will spread principal reductions over three years and let mortgage investors share in any subsequent increase in value when a home is sold.

Some mortgage companies say principal reductions are best used when borrowers are deeply underwater. PennyMac Loan Services LLC will consider reducing principal if the borrower is likely to remain underwater even after three or four years of loan payments, said Steve Bailey, chief servicing officer for PennyMac, which has used principal reduction in 58% of its modifications.

—Dan Fitzpatrick contributed to this article.Write to Ruth Simon at [email protected] and Nick Timiraos at [email protected]

How principal reduction could work

The Ocwen program described above is the only way principal reduction could work in the real world.

Let’s say a borrower in Las Vegas owes $400,000 on a house currently worth $200,000 — a common occurrence there. Let’s say the owner is given a principal reduction down to $200,000, but if they sell the house for a price between $200,000 and $400,000 the overage goes to the lender to recover the loss from the principal reduction. What that arrangement would effectively do is release the borrower from the property. They could sell without future financial liability, and if prices go up all the way to their entry point, they may even have equity again.

Of course, this approach would strongly encourage people who obtained principal reductions to immediately sell their homes. It would be far wiser to sell the house, buy one across the street, and keep the appreciation on that one. Hmmm…. I guess it doesn’t work after all….

If you want to explore more on this issue, I recommend one from early in the IHB: 04-16-2007 — How Homedebtors Could Avoid Foreclosure — A look at a potential financing mechanism which might be used to assist homeowners who are underwater. It also examines the potential implications of the widespread use of such tools.