Aggressive Reductions of Principal in Mortgage Mods Reduces Borrower Recidivism

I’ve been asserting for some time, based on the comments from mortgage counsellors, that mortgage mods that do not substantially reduce principal balances don’t make enough of a difference to the borrower to change outcomes. And with banks and servicers looking at 40%+ losses on many foreclosures, they can reduce principal a lot and still come out ahead.

Mortgage servicers have been experiencing high recidivism rates on loan mods, leading commentators to say that mods don’t work. However, it has been reported (Calculated Risk) that many of the so-called mods were payment catch up plans, and not true mods, but the composition of the balance was unclear. Thus it was similarly not certain whether my view was correct.

Some support comes from Wilbur Ross, no soft touch, but a distressed investor (they are not called vultures in polite company). He owns American Home Servicing, the biggest third party servicer in the US. He also offers a program for how to deal with the housing crisis.

Note that American Home Servicing has done a lot of loan mods. Ross makes no mention of the supposed legal obstacles to making mods. That suggests the issue is way overblown (as in investors in theory might sue, but no one is a big enough holder in any one trust for it to be worth the trouble). That also indicates the real obstacle is some combination of servicer greed (lack of financial incentives to do mods, costs of adding staff to do mods) and concerns about impact to bank balance sheet. Recall that AHS is third party. Most other big servicers are part of big banks. If the servicer starts offering mods, say, with 25% principal reductions, it would suggest that any similar loans held by the parent bank ought to be marked down to the same level.

From HousingWire:

[Wilbur] Ross has plenty of skin in the mortgage servicing game, as he owns Irving, Tex.-based American Home Mortgage Servicing, Inc., which recently became the nation’s largest third-party servicer with the acquisition of a large portfolio from Citigroup Inc. (C: 2.51 -13.75%). See earlier coverage.

Last week, Ross told HousingWire in an interview that he thinks the best way to motivate lenders, servicers, and homeowners work together on modifications requires far more than what’s been proposed so far. In particular, he believes that what’s needed is aggressive principal modifications for borrowers most in need. He has said that his American Home servicing shop has seen six-month recidivism rates below 20 percent — compared to the 50 or 60 percent standard in the industry — because the servicer has been aggressively looking to cut principal balances.

“The price of housing needs to be cleaned out. The Obama administration could right-size every underwater home and reduce principal to fit the current market value of the home. If they are going to deal with it they have to deal with it in a severe way,” Ross told HousingWire. “They also really need to consider all borrowers who are underwater, and not just the ones that have gone into default.”

The Homeowner Affordability and Stability Plan does some of that, but doesn’t go far enough, Ross suggested. “The have to reduce the principal amount of loan, not just nonperforming loans, but also performing ones,” he told CNBC. “Why should a guy who’s not paying benefit, while some poor citizen who’s struggling to make the payments gets stuck with the mortgage?”

His own plan looks something like this:

1. The lender takes a write-down in principal, and the servicer takes a similar hit on any servicing strip on the newly-reduced UPB.

2. After principal reduction, the government guarantees half of the remaining principal the lender now holds.

3. This guarantee of half the principal can now be sold into the securitization market, which will give the lender an income stream on the home again and offset some of the losses the owner of the loan has to take when they write down the principal.

4. When the house is sold, if the value of the home has gone up at the point of sale, the homeowner and the lender share in the profits earned on the gain.

Ross isn’t the first to suggest an home equity sharing plan, and there are clearly strong complexities in how any such plan would be put together, particularly as it relates to second lien holders and/or investors in junior bond classes. But the fact that a large investor with such a strong hand in the servicing business is suggesting it’s possible at all to accomplish is something that perhaps bears more attention than the idea has been getting as of late.


Originally published at Naked Capitalism and reproduced here with the author’s permission.

2 Responses to "Aggressive Reductions of Principal in Mortgage Mods Reduces Borrower Recidivism"

  1. TA   February 20, 2009 at 9:38 am

    Re-posts from yesterday’s EconoMonitor thread:”…two key elements are key to avoid a near-depression and still seriously missing: …and a more aggressive and across-the-board reduction unsustainable debt burden of millions of insolvent households (i.e. principal reduction of the face value of the mortgages, not just mortgage payments relief). Prof. Roubini 2/19/09Re-post from previous thread:As discussed here on several occasions, there is only one solution to ending the housing crisis – the elimination of “negative equity”. Everything else is window dressing.Plans relying on lenders’ voluntary principal reduction are fool hardy at best, and a complete waste of valuable resources at worst. It’s simply not in the lender’s economic best interest to voluntarily reduce outstanding principal.The plan unveiled today stresses affordability by manipulating the mortgage interest rate to achieve a desired payment (it’s too complicated to explain here, read it and set-up a spreadsheet model). It doesn’t make any provision for achieving parity between a home’s current market value and its mortgage principal balance. Without that, it’s DOA.But more affordable mortgages aren’t the issue; it’s which party incurs the loss in today’s “short sale” environment. Lenders won’t and sellers can’t so the R/E market remains seized.Make no mistake; the solution to the housing crisis will entail the elimination of “negative equity” by mandating the reduction of principal. There is no other viable solution. As others have noted, there will be no recovery without addressing the debt overhang (principal reduction not principal set asides).I can hear the screaming…moral hazard, legal precedent, rewarding bad actors…STOP! There is no other way out. The only relevant issue remaining is when. Hopefully sooner rather than later, as @ 10,000 homes go into foreclosure each day.Hide reply Reply to this comment By TA on 2009-02-18 16:51:07But this is only a temporary fix. The real issue is falling wages and, job losses.MarkHide reply Reply to this comment By Mark on 2009-02-18 23:47:01Mark,It’s a three legged stool; banking/finance, employment/income, and real estate. Advocates for each make compelling arguements for fixing their “leg” first.My point here is simple: there will be no economic recovery without first resolving the housing crisis, and resolving the housing crisis requires the elimination, not partition or set aside, of “negative equity”.Many advocate letting the market take care of itself, and I’m in complete agreement, to a point. Letting real estate prices find their equilibrium point (bottom) on their own is fine, but then what? The steeper prices fall, the wider the “negative equity” gap becomes.If lenders won’t voluntarily close the gap (i.e. incurring the short sale loss), and sellers can’t close the gap (i.e. marginal savings & retirement funds) the next viable agent is the federal gov’t.Everyone is looking for a bottom signal. IMHO, THE bottom signal to watch is how “negative equity” is resolved. Although it’s likely economic data will indicate otherwise, the “all clear” signal to watch for is the federal gov’t’s plan for eliminating “negative equity”.Reply to this comment By TA on 2009-02-19 07:06:33Before the legal beagles, finance wizards and general naysayers pounce, it’s understood the federal gov’t’s mandated reduction of mortgage principal is unprecedented (as best I can tell). However, it’s not only the ultimate “outside-of-the-box” solution, it’s the only viable solution.Hide replies Reply to this comment By TA on 2009-02-19 09:17:40There has always been the last resort of a debt for equity swap to reduce debt. If debt in the form of principal is to be eliminated, it only makes sense for the one taking the haircut to get the equity. Therefore, what you propose would have to include either the government or the banks sharing in the proceeds of any future sale of the home, either any equity that is in it currently or its future appreciation. This would be in essence a debt for equity swap.Anything else is extreme moral hazard.Hide reply Reply to this comment By ex VRWC on 2009-02-19 10:15:21VRWC,The problem with “debt for equity swaps” in this environment is the strong likelihood of minimal appreciation going forward. With lenders returning to more conservative lending practices, it’s reasonable to project meager future appreciation for most real estate products. In such an environment, the issue then becomes how a homeowner’s account would be settled if the gain from a future sale didn’t satisfy the forgiven debt.IMO, it’s also unlikely the homeowner will share in the partition of loss. It’s more likely to be shared between the lender/investor and the federal gov’t. In all likelihood, the federal gov’t will incur the full loss by offering offsets (tax credits) to the other loss parties.I think it’s important to keep in mind that “negative equity” is a consequence of rapidly falling prices which isn’t confined to any one mortgage type (i.e. Sub-prime, Alt-A etc.). As such, it touches almost everyone selling and purchasing in today’s market.“Anything else is extreme moral hazard.” Agreed. It’s highly controversial and bitter medicine for most, but it’s also the only viable solution.Hide reply Reply to this comment By TA on 2009-02-19 12:41:53the issue then becomes how a homeowner’s account would be settled if the gain from a future sale didn’t satisfy the forgiven debtThis is the classic short sale. If the government takes the loss through tax offsets, you basically reward the homeowner and the lender, with the government taking the downside.If government taking the loss is the only way, then so be it. Perhaps they could create the equivalent of a lien on the property, such that with some future appreciation the government can be made whole. Such a lien could be a factor in the purchase price of the home (ie, a discounted purchase price would be set in exchange for the consideration that the lien is owed to the government).Reply to this comment By ex VRWC on 2009-02-19 13:04:33

  2. Guest   February 22, 2009 at 9:30 pm

    If the loan balance to zero, we should move to zero loan default.The reduction of principal to current market values creates another moral hazard. Borrowers don’t have any skin in the game. The gains are privatized and the past losses socialized by the banks. Which in turn gets the banks crying for a bailout to socialize their losses.The current house values are still too high in the land of forclosures (south-east coast and west coast)Berzerkelian