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.

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  1. Born Again Democrat

    Instead of modifying mortgages, why not modify foreclosure law to allow occupants to remain in their houses and pay rent at the current market value?

    Maybe this is a cockamamy idea (probably is, most of mine are), but I can see some good in it: First, persons who can’t keep up with their too-high mortgage payments (because the house is overpriced) could afford the rent. They need not fear eviction and homelessness so much.

    And second, the mortgage holders (whoever they turn out to be) would continue to receive a stream of income reflecting the true market value of their propoerties.

    Everybody takes a haircut, but with a lot less pain and disruption.

  2. Anonymous

    Stepping down mortgages.
    When I got a mortgage, I was pre-approved at a certain price ceiling. So then I get into trouble
    Instead of work-outs with haircuts why can I not take this mortgage, and return to a pre-approval state. WITH the original terms.
    I then must use it to buy a cheaper house from someone who also wants to move down a step.
    We do end up with a forclosed McMansion at the top of the chain but perhaps save three or four foreclosures in the stepping down. At the bottom the subprimers are without a house. In a perfect world, subdivide the Mcmansion and rent it to the subprimers

  3. Swedish Lex

    This could perhaps be a good starting point to modify those billions of mortgages in central and Easter Europe that are denominated in non-domestic currences, normally euro or CHF.

    House prices are now plunging as are the local currencies, i.e. borrowers are being hit twice.

    It is a mystery how authorities could allow large parts of the populations make their largest financial commitment in a foreign currency.

  4. alex black

    To Born Again Democrat –

    Why would a homeowner who knows he is going to lose his home do this? If he gives the bank a deed in lieu of foreclosure, it smacks his credit down just as much as a foreclosure, so no gain there. So his choice is: deed the house to the bank and start paying market rent from day one, or stop making his mortgage payments, knowing that banks are reluctant to foreclose (for many reasons), and he’ll get to live in the house for 18 months rent-free.

    Maybe Ned Flanders from the Simpsons would start coughing up rent to the bank, but I suspect most would rather pocket the 18 months worth of free rent, all else being equal.

  5. Jojo

    There will be many unhappy people if selected citizens who essentially tried to game the system get their principle written down. There could be real blood shed in the aftermath.

  6. Anonymous

    Yes that is the problem with reducing principle, Those who are not in trouble will be asking for the same.In fact if you are prudent you should try to get yourself in a debt position where you too can get a government handout. This is a scheme which could work outside of the US in conjunction with proper bankruptcy. The home owner would keep the house have smaller payments but would have the punishment of not being allowed to have any more credit for a very long time. In the US bankruptcy appears to be some sort of wishy washy slap on the wrist rather than any sort of deterant.

    The single greatest obsticle in the US is not having proper bankruptcy and not having non recourse mortgages. There is no real punishment in the US for getting into debt over your head.

  7. M.G.

    I am at odd with the US system of mortgages: first it pushes people to get a mortgage based on false assumptions, like prices of the houses always go up, then it pushes foreclosures which drags down prices thus increasing foreclosures. I believe that changes in the law and mortgage conditions and market are overdue.

  8. Anonymous

    Using the Indymac bank mods as a reference the typical distressed homebuyer had a $275,000 mortgage and needed about $425/month in payment relief to stay in the home.

    Allowing these distressed homeowners to refi at the original purchase price and providing them a US government low interest bridge loan of around $20-30,000 with no payments for, say, 5 years would seem to do the trick IF keeping the house was the goal.

    This would stop the flood of foreclosures and bank writedowns on bad loans as well as give the distressed homeowner 5 years or so to get their finances in order. Say payoff that car loan, reduce the credit card debt etc, get a few
    pay increases etc over a 5 year period to be able to handle their $425/month shortfall. stabilize home values.

    Offering principal writedowns to deadbeats is a horrible ‘solution’.

    The goal should be offer financing and time for deadbeats to make good
    on their original commitment.

  9. ruetheday

    Just wait until the unemployment rate breaks 10% and all of the prime borrowers suddenly find themselves unable to find work and thus unable to pay their mortgages. Tap into savings? They’ve been decimated by the market collapse.

  10. Anonymous

    Even though Ross is a pirate, he is nibbling at the edges of a workable plan, with certain other features.

    The banks also modify interest rates, converting all to 30 fixed, assumable.

    The problem is that housing is still over priced. The modification must be a combination of principal reduction and interest rate subsidy that supports the high price of bubble housing while allowing the underlying market to stabilize at the market clearing price. Equal monthly payment, at higher price, but at lower rate.

    New loans for housing are not eligible and are written at market rates and prices. The assumable loan feature can support the bubble price until the house is paid off.

    The MBS holders take the haircut on principal and interest. Better than total default.A secondary market can begin to function because the toxic MBS has a value at perhaps 60 % of it’s face. A pretty sweet deal for the current holders, and the banks involved get a natural stabilization of reserves.

  11. Kafka

    I would submit that Ross is pimping his book as all these guys who have started to dabble in toxic MBS, like Ross, are nervous of getting slaughtered by modifications. Hard to make dough off these instruments if they are contractually written down and modified (especially in a short time frame). Ross is just coming at it in a more inoffensive way, as opposed to saying government forced modifications may screw many of the dudes who bought MBS with the idea of a quick flip for profit. The thing I don’t understand is all the gurus keep saying many who can not afford their mortgages are unemployed through no fault of their own and thus, should have their mortgages modified to save the planet. How does modifying the mortgage of an unemployed person solve anything especially in a period of rising unemployment?

  12. JuanB

    Why not simply extend the life of the mortgage?

    Changing a 30-year loan to a 35- or 40- year loan will lower monthly payments to more reasonable levels and would probably do less damage to balance sheets. Plus it’s easier to do since it doesn’t modify rates or home values on contracts.

  13. Anonymous

    I believe that irresponsible spending and financial illiteracy are high on the list of causes for mortgage defaults. A loan modification that doesn’t restructure the entire debt of a borrower and put limits on future consumer debt and doesn’t require the borrower to go through some kind of financial literacy courses is just a default waiting to happen.

  14. K T Cat

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

    The government guarantees this with what, precisely? Our government is rapidly turning the economy into an inverted pyramid where ever-increasing burdens are piled onto an ever-decreasing set of productive members of society.

    This will end as an existential crisis for government. The sooner we stop living in a fantasy world where spending and guaranteeing is decoupled from earning the better it will be.

  15. Anonymous

    real estate has fallen to the point of no return in many areas. What I mean is if somebody is $100-$200 under water, it’s just a matter of time before he figures out defaulting is the best course. Whay pay $20k for a new roof when you can buy a better cheaper home next door?
    It then becomes a matter of what is healtiest for the ecomony. DO we let this problem drag on for years becuae of fear that equity has been wiped out only to eventually foreclose because of needing to move for a new job? or do we get it done now with cram downs and priciple reductions which stabilize housing and get the economy on track so people spend again due to feeling good about owning a home and not being trapped in a home.

    Mark Mc

  16. Anonymous

    Is it even worth talking about modifying mortgage loans without including the equivalent debt such as student loans, credit cards, auto loans, etc. as well as the folks who are debt free?

    Angry does not describe what I feel. I know it sounds crazy but for the most advanced of us, we still have steam emerging from our heads. As it is there is a growing majority dissent against this ungodly unfair mortgage plan Obama came out with.

    I don’t understand how there can be so many so called “experts” out there suggesting we give a gift of money to 5 to 10 percent of this population no questions ask.
    You want suggestions? .. offer rock bottom welfare and public housing to everyone and if they want better then get a job. Any job not just cry victim because you can’t find a high paying job in your field. Those days are over. We need to “reset” this economy as Mr. Microsoft Steve quoted and the sooner we do the less revolutionary type war we will avoid. Until we do there is going to be a deep kind of hatred growing among us that will be the end of us. In retrospect Obama was a huge mistake and has the potential to become the real death to America.

    My best guess is there will be a mortgage revolt where 50 to 70 percent of this country stops paying their rent and mortgage. Can you imagine? There is nothing the government could do. They don’t have the resources to make people pay.

  17. Anonymous

    Mark Mc

    “do we get it done now with cram downs and priciple reductions which stabilize housing and get the economy on track so people spend again due to feeling good about owning a home and not being trapped in a home.”

    Can you guarentee us this will get the econmomy on track? Are you willing to put your life on the line to support this statement? Explain how and why you think this would stabilize the real estate market? Have you ever dug deep and gone to mortgage broker or realtors or appraisers forum to see how they conduct business? Do you understand that the real estate business model broken with many “conflict of interests” thought out this model? Not one red cent should be spent until we clean up this fraudulent sick business model. As we write today there are mortgage brokers gaming the system today but with FHA and USDA rural “no down payment loans”. Take a day out and visit these forums.

  18. Anonymous

    rearranging deck chairs on the titanic and slowing capital redeployment to other starved segments of the economy where the REAL growth awaits catalysts.

  19. Anonymous

    Principal reductions make me ill. If this occurs then responsible home owners who are current on their payments and didn’t overspend on their home purchase should receive similar treatment. This country is going to hell in a handbasket.

  20. eh

    So “nationalize” the houses too. If it’s good enough for the banks and their common shareholders, then it’s good enough for ‘homeowners’ too — ‘zero them out’, especially the ones who put nothing down.

  21. Anonymous

    Wait a minute… don’t we end up with situations where the banks have already sold a mortgage bond, and now they create another on top of that?

    And what’s to prevent somebody related from taking a loan in another bank, so they can buy out the house before the value goes above the point where the profit has to be shared?

  22. Anonymous

    The “equity kicker” is how creditors will prevent losses by stealing money from the homeowner:

    “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.”

    The purpose of non-recourse loans is to prevent creditors from making bad loans. If creditors make bad loans, then they lose money. That is, until they take it back via some government sponsered “equity kicker” plan. Wilbur Ross is just looking out for his interests, what else is he supposed to do?

  23. Anonymous

    Banks don’t want principal mods because they are holders of AAA securitizations at higher $ prices. If you reduce principal via mod instead of b/k the loss gets spread evenly over all tranches instead of bottom up. This results in banks having to take write-downs to the AAAs. So even if bigger loss in foreclosure it may have a smaller impact on the banks balance sheet due to it hitting junior classes first, that is its a way to defer recognizing losses to the AAAs.

    I think we don’t need govt intervention or support for borrowers or banks. We have a process, bankruptcy, for dealing with all these issues and it will allow home prices to reach a market clearing level which is what is needed.

  24. artichoke

    A lot of those formerly AAA tranches aren’t AAA any more, for example the “super senior” AAA tranches of subprime pools.

    Nevertheless the point is apposite: there is a priority rule among tranches, and the BK process may deal with it differently than a principal reduction outside of BK.

  25. Anonymous

    Agree on subprime. I think all that is left in that market is the final play-out of realized losses versus implied losses on the bonds.

    I meant as related to Alt A, which has had some downgrades, and prime which have had few. We are heading to losses there and the point was trying to make is its in the banks best interest, short term anyway, to do foreclosures as opposed to mods so as to keep the price illusion of the AAAs for as long as possible. That becomes impossible if start allocating losses to those securities via mods. Whether its in their best interest long term not sure as I think the dominate factor is the borrowers job status/income one year or so out. As I stated before though, think its all best left to the b/k process without intervention on either side.

  26. Anonymous

    i just heard on cnn…haven’t verified the accuracy…over 90% of mortgages are paid on time. If this is so, why do we need $75 billion to save 10% or less of reckless buyers??

  27. Anonymous

    My best guess is there will be a mortgage revolt where 50 to 70 percent of this country stops paying their rent and mortgage. Can you imagine? There is nothing the government could do. They don’t have the resources to make people pay.

    Sure they do. They’ll just give law enforcement a percentage of recovered money. Lots of people would gladly give up their neighbors for a piece of the swag.

  28. MyLessThanPrimeBeef

    I think you are reducing your capitalistic principles with this principal reduction idea.

    But if you insist on it, perhaps the first place to try it out would be for the government to do ‘principal’ reductions on, say, income taxes owned by its citizens to the levels they can afford.

    Then we will find out how close the audacity to hope is to the audacity to hallucinate.

  29. Andy

    The shared appreciation model holds great appeal, and I hope more expert comment supports it. It punishes the borrower by excluding a portion of the real estate price rise from being realized as a gain(I'm thinking if you reduce the principal from 100 to 80% loan-to-value, then in a subsequent sale the borrower only gets <=80% of the sale right?). It punishes the lender/lien holder by generating lower monthly income/mbs value. It accomodates: the borrower by letting them stay in housing they like; the lender by avoiding foreclosure and creating a longer term asset.

    I believe tax statutes essentially prohibits this, but Treasury could change w/(out?) Congressional approval.

    Any time you could put "Shared" into a policy change to address a level of irresponsibility would certainly garner broad support.

  30. Mara

    It’s apparent there will not be a solution that will be palatable to everyone. But for the individuals who are all sweaty about “deadbeat” homeowners being rewarded, I would like to bring your attention the following: you’re arguing about pennies compared to the thievery that continues unabated in the form of govt sponsored graft in
    1. War profiteering (why isn’t haliburton declared a terrorist organization?)
    2. Literally pallets of billions of US$ “lost” in Iraq
    3. The costly actions of the PPT to shore up share prices (this one has been happening regularly for years)
    4. “Bailouts” of the very corporations that colluded to create bubble conditions in the first place.
    5. If you really want to go nuts, why is the Treas paying interest to the Fed to print their own damn money?

    You (the taxpayer) are paying for all these boondoggles, but you’re only willing to punish the smallest at the bottom of the chain. Jerks like Madoff and Alan Stanford don’t even get put in jail!

  31. Markel

    The intellectual value of many of these comments is zero. If you’re not going to read the original post, please refrain from commenting to avoid wasting others’ valuable time.


    The proposal here is to reduce principal balance for 8.8 million homeowners to date. That’s just under one out of every five homes with mortgages (a third of homes have no mortgage). Estimates differ on how many of these will walk away–GS said 25%, I think Roubini said half. There isn’t yet a lot of data on how much “ruthless default” there is–homeowners who could make the payment, but choose not to. So there is a lot of ambiguity about how much loss we are mitigating here.

    What I’d like to see is a realistic estimate of how much this proposal would cost the lienholders and the government, so we could do a cost benefit.

  32. MyLessThanPrimeBeef

    Here is an interesting puzzle: Who has done more damage to the world – the intellectuals or non-intellectuals?

  33. Paul

    Principal writedowns could have the same effect as approving short sales, as the beneficiaries of the principal writedown could quickly put the house back on the market. More inventory is not needed right now. The bank may realize that if homeowners want principal writedowns to sell the house, they can foreclose and realize a similar result.

    On the other hand, the benefit from interest rate decreases is proportional to the time that the homeowner stays in the home.

  34. lineup32

    The reason the banks do not want to do principal reductions is that they are getting a better price from the market. REO’s are what is selling today and its not unusual for a bank in my area to fix up these places and then put them on the market and get multiple bids!
    The only places they would give principle reductions is the worst sections of town that require arm guards to drive around and in that case the homeowner is probably so far behind, no job, no money that it is beyond saving.
    I looked at an REO today that Downey Saving is listing at $399K.
    The original loan was 450K! I offered 250K cash and given the neighborhood thought it was a good deal for the bank but they were not interested since investors are flocking to the area looking for deals!!!!!!!!

  35. Anonymous

    Markel said,

    “The intellectual value of many of these comments is zero”.

    Well maybe so, but then, we can’t all be Markel.

    What is puzzling to the this contributor is why Markel would then ask for a “realistic estimate of how much this proposal would cost the lienholders and government so we could do a cost benefit”?

    To this I can only ask Markel what is ‘realistic’ and how useful is an ‘estimate’. Isn’t that precisely the problem? How to value various real estate loans and properties in an uncertain or non existant market. But maybe I just don’t ‘get it’.

  36. Loan Modification Company

    An interesting and informative article. Thanks for sharing this info post.

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