Apr092012

Principal reduction transfers the pain from lenders and loan owners to everyone else

I have two strongly held views on foreclosure and principal reduction that are completely at odds with the drivel in the mainstream media.

First, foreclosures are not a problem. In fact, foreclosures are essential to the economic recovery. All efforts to avoid or delay foreclosures are counterproductive.

Second, principal forgiveness is the worst policy option. The clamor from the left to give away my tax dollars to loan owners is getting louder and louder. It’s simply bad public policy, and it should not be embraced by policymakers.

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Sharing the Pain and Gain in the Housing Market

… The big question before lenders, investors, and policymakers today is how to avoid another wave of costly and economy-crushing foreclosures.

While this issue is being pushed onto policymakers by pandering politicians on the left, this discourse is loaded with false assumptions. First, the erroneous idea that avoiding foreclosures is good for the economy. It’s simply not true. Our economic malaise is largely caused by the unresolved foreclosures and mountains of overhanging bad debt. The debt is the problem. The foreclosures are a cure. Second, the wave of foreclosures is only costly to the banks. The rest of us are being asked to preserve the wealth of bankers and investors in banking stocks and bonds. That isn’t right.

There are several ways to lower an at-risk borrower’s monthly payments and increase the chance of repayment: refinancing to today’s historically low interest rates, extending the loan’s terms, modifying the interest rate, deferring payments, or lowering the amount the borrower actually owes on the loan—so-called “principal reduction.” In most cases the lender or mortgage investor responsible for the loan considers all of these options when deciding which intervention is best for the specific borrower.

That is, unless the loan is owned or guaranteed by Fannie Mae or Freddie Mac, the country’s two biggest mortgage finance companies. Fannie and Freddie have yet to embrace one option—principal reduction—as a viable foreclosure mitigation tool.

In fact the two mortgage giants, which are now operating under government conservatorship, are forbidden from lowering principal on any mortgages they own or guarantee by their regulator, the Federal Housing Finance Agency, or FHFA. That’s the case despite a growing consensus among economists, investors, academics, and consumer advocates that principal reduction is often the most cost-effective way to avoid unnecessary foreclosure for certain groups of borrowers.

The “growing consensus” meme is complete bullshit. A chorus of left-wing panderers are cranking up the volume, they the only people they are persuading this is a viable policy are the loan owners who mistakenly believe this will help them and perhaps the lenders who see the false hope of principal reduction as helpful to keep loan owners making payments.

Principal reductions are particularly effective for deeply underwater borrowers that are facing long-term economic hardships, such as a permanent reduction in wages or long-term increases in unavoidable spending.

If loan owners are facing long-term economic hardship, why aren’t they short-selling their homes and downsizing? If I am suddenly unable to pay my rent, I am expected to vacate the property and move into something more affordable. Why aren’t loan owners expected to do the same?

What they are proposing is to keep people into houses they can’t afford and have no business being in. This crowds out those who can legitimately afford the property and makes them either pay more or settle for less — and they are being asked to subsidize the people crowding them out and occupying what should be their home.

These families are at high risk of default and often cannot see the long-term upside from making expensive monthly payments into a bad investment.

That’s because there is no downside, and these people should strategically default.

With more equity in their home, these borrowers would be more likely to stick it out in tough economic times by making deep cuts to savings or other areas of spending.

Now we get to the real agenda — keep borrowers in perpetual servitude. People who should strategically default may not if given a small dose of false hope.

These are homeowners worth helping.

Why? How is keeping them in servitude to lenders helping them? That sentence should read, “these are lenders worth helping” because that’s what they are really proposing.

Foreclosure is often the worst-case scenario for everyone involved, but especially for underwater borrowers who boast close ties to their communities and prefer to stay in their homes.

Bullshit. People can rent a home and stay in their community. Further, if they want to exercise their preference to stay in their home, they should pay for it.

.. And each foreclosure in the neighborhood decreases the value of everyone else’s home, which is a drag on the local housing market.

As a renter, I can honestly say I don’t give a crap about the neighborhood resale values. I care a great deal about my money being used to prop these values up artificially.

Reducing principal is the only way to rebuild an underwater borrower’s equity while permanently lowering monthly mortgage payments. … But FHFA is not convinced principal reduction is ever the best option for Fannie or Freddie.

To be fair that position may make sense if the goal of the agency is to protect the short-term interests of Fannie and Freddie. Principal reductions require the lender to take a hit on their books today in order to save more money tomorrow by reducing defaults and foreclosures. In the case of Fannie and Freddie, that may mean billions of more dollars in temporary support from taxpayers, who have already invested $150 billion in the companies since 2008.

That’s exactly why it shouldn’t be done. It will cost more now, and there is no real evidence it reduces losses going forward. The only way this policy reduces losses is if it prevents loan owners from strategically defaulting by giving false hope of future equity. That’s a difficult policy to embrace.

But it’s important to realize that over the long run, the goverment-sponsored enterprises are projected to lose even more money if they don’t act today. …

To maximize returns to Fannie and Freddie, we propose a pilot program that reduces principal—often by as little as 5 percent or 10 percent—without creating skewed incentives for borrowers. Through so-called “shared appreciation” modifications, Fannie or Freddie agrees to write down a portion of the principal on deeply underwater loans in exchange for a portion of the future appreciation on the home. The borrower has a reason to keep paying, while the lender benefits when home prices eventually stabilize and rebound.

False hope in exchange for tangible future benefits? Any borrower who does this should sell the moment they are no longer underwater. Why share equity when they don’t have to? They can sell the house subject to a shared equity agreement and get into one where they don’t have to share anything.

… And by phasing in the principal reduction—say, over the course of three years contingent on meeting every monthly payment—the borrower has additional incentive to stay current on their mortgage. Both of these program rules deter borrowers from defaulting on their loan just to get a reduction in principal, what some critics call the “moral hazard” problem.

The dangling carrot of false hope. This is a clear attempt to get people to keep paying who would benefit more from strategic default.

That said, we fully understand that principal reductions should not be available to everyone. As is the case with any loan modification, the principal reduction must be in the best interest of both the borrower and the lender, or in many cases the mortgage investor that owns the loan. This consideration must be done on a loan-by-loan basis.

Consideration on a loan-by-loan basis is code for “we have no idea how to make this work as a general rule.” People who propose policies they can’t make work shouldn’t be taken seriously.

At this point, we don’t have enough data to determine when exactly principal reduction is the best option for Fannie and Freddie compared to other modifications such as interest rate modifications or principal deferral. Indeed, that’s the main reason for a targeted pilot.

So if we throw several billion dollars at the problem, we might be able to figure out how to make it work? Give me a break.

For now we recommend Fannie and Freddie focus on borrowers that are most likely to benefit from a reduction, specifically borrowers that:

  • Have a mortgage that’s worth at least 115 percent of the home’s current value
  • Are either delinquent on their mortgage payments or at imminent risk of default
  • Face a long-term economic hardship, such as a non-temporary decrease in income or a permanent increase in unavoidable spending
  • Do not have private mortgage insurance or a second lien, such as a home equity loan

If you focus this program on those who can’t afford their underwater mortgage, who benefits? If the owner had equity and couldn’t make the payments, they would be forced to sell, and nobody would care. Since they are underwater, this benefits a lender who would otherwise have to take a loss when the borrower sold the property to move into something affordable.

The appearance versus the reality

Joe Six-pack loan owner favors principal reduction because he believes his lender is going to reduce his mortgage balance to fair market value with no strings attached. Joe further believes he will get to keep all the upside once prices bottom. In other words, a typical loan owner believes free money is on the way. That isn’t going to happen. The cost is simply too large. Loan owners as a group are $3.7 trillion underwater. There is no way the government can afford to make all of them whole, and I would be leading the rebellion if they tried.

Any principal reduction program would actually benefit a very small fraction of underwater loan owners, and those the receive principal reduction will likely see their balance reduced by a small amount so they are slightly less underwater.

The reality of principal reduction is that many will hope for some benefit, and very few will obtain it. The real purposes are twofold: (1) pandering politicians get to look like they did something — just like the robo-signer deal, if you recall — and (2) loan owners will gain some false hope to keep them making a few more payments before they implode — also just like the robo-signer deal.

Do any of you see it differently? Am I too cynical, or do I see reality through the spin?