Push For Principal Reductions Generates Pushback

As the American Banker's "cheat sheet" summary of the 27-page settlement proposal presented by state attorneys general to the large loan servicers makes clear, the state attorneys general are pushing principal reductions on loan servicers. Servicers are pushed to consider principal reduction as a first option when possible, although the term sheet makes it clear that the subject has also been "reserved for further discussion." Servicers must evaluate certain delinquent loans with a loan to value ratio of greater than 100%, and offer principal reduction if that would result in a better net present value than a standard modification. Instead of forbearing on principal, the draft agreement says servicers shall begin "conditional forgiveness of principal" if a loan modification performs well. "Standard shall be that one-third of forborne amount is forgiven for each successive year that the borrower complies with loan modification terms over a three year period," according to the term sheet. The state AGs and other federal enforcement agencies are also pushing for the reduction of mortgage debt in the bankruptcy process. "Servicer shall consider implementation of a special loan modification process for bankruptcy cases where the borrower (a) is considered for voluntary principal reduction to fair market value of property while other unsecured debt is discharged; or (b) as part of a Chapter 13 plan, the interest on the borrower's first lien is reduced to zero for five years and then reamortized at a market rate for 25 years at the conclusion of the five year payment plan," the term sheet says. The term sheet also touches on second liens, requiring that for all loan modifications, including principal reductions, second loans must be modified proportionately to the first lien or extinguished at the time the modification is offered. As the New York Post noted today in an exclusive article, loan servicers are responding to this pressure by telling the AGs that they can do something that is physically impossible to themselves, although likely to be quite pleasurable if such an act could, in fact, be consummated. The deal proposed by federal regulators and state attorneys general in a 27-page draft settlement distributed to the nation's five largest mortgage lenders last week is a "non-starter," sources told The Post. One bank official said that the draft, if implemented in its current form, would force many of the nation's banks to stop underwriting mortgages altogether because they wouldn't be able to manage the new costs of servicing home loans under the proposed agreement. While some pundits think that servicers are merely posturing at this point (including threats contained in the Post article to get out of "Mortgage Dodge" altogether), the loud and increasingly bitter grumblings I've heard from long-time mortgage bankers in this relatively stable portion of the US lead me to believe that the settlement, coupled with the trifecta avalanche of upcoming Dodd-Frank regulations, recent FRB regulations in the mortgage area, and the prospect of the CFPB's loving ministrations, have many smaller-to-mid-sized mortgage originators seriously considering (and in some cases, actively seeking) other lines of business. Sure, there will always be someone available to make a loan secured by a house, perhaps the Guido ("Bananna Lips") Spignoli Mortgage Company or the King Faisal bin Abdul-Aziz Al Saud Memorial Sovereign Wealth Mortgage Fund for Boys, but I think that making it increasingly more cumbersome and expensive to make, service, and/or invest in mortgage loans will accelerate the trend I've previously noted: the concentration of the mortgage origination and servicing business in the hands of a few very large "players." The "principal reductions suck" crowd got a boost from three Federal Reserve Bank economists (h/t Calculated Risk), who argue that principal reductions don't work. The closing three paragraphs of their position papaer are worth reading in full. Ultimately the reason principal reduction doesn't work is what economists call asymmetric information: only the borrowers have all the information about whether they really can or want to repay their mortgages, information that lenders don't have access to. If lenders weren't faced with this asymmetric information problem-if they really knew exactly who was going to default and who wasn't-all foreclosures could be profitably prevented using principal reduction. In that sense, foreclosure is always inefficient-with perfect information, we could make everyone better off. But that sort of inefficiency is exactly what theory predicts with asymmetric information. And, in all this discussion, we have ignored the fact that borrowers can often control the variables that lenders use to try to narrow down the pool of borrowers that will likely default. For example, most of the current mortgage modification programs (like the Home Affordable Modification Program, or HAMP) require borrowers to have missed a certain number of mortgage payments (usually two) in order to qualify. This is a reasonable requirement since we would like to focus assistance on troubled borrowers need help. But it is quite easy to purposefully miss a couple of mortgage payments, and it might be a very desirable thing to do if it means qualifying for a generous concession from the lender such as a reduction in the principal balance of the mortgage. Economists are usually ridiculed for spinning theories based on unrealistic assumptions about the world, but in this case, it is the economists (us) who are trying to be realistic. The argument for principal reduction depends on superhuman levels of foresight among lenders as well as honest behavior by the borrowers who are not in need of assistance. Thus far, the minimal success of broad-based modification programs like HAMP should make us think twice about the validity of these assumptions. There are likely good reasons for the lack of principal reduction efforts on the part of lenders thus far in this crisis that are related to the above discussion, so the claim that such efforts constitute a win-win solution should, at the very least, be met with a healthy dose of skepticism by policymakers. Don't expect politically and ideologically driven "settlement" demands to ever be derailed by "a healthy dose of skepticism" or, for that matter, an acceptance of reality. It's not the way the world is that matters to many of the people pushing political agendas in the banking world these days, it's the way they want the world to be. That's why these types of efforts usually unleash the power of the law of unintended consequences, and why the results of the operation of that law are so often so unpleasant.

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