Principal Reduction Debate: Focused Attention Needed

by devteam March 11th, 2011 | Share

Three FederalrnReserve economists are out to debunk the theory that reducing principalrnbalances on mortgage loans is a no-cost cure for the housing crisis. The three,rnKris Gerardi, Federal Reserve Bank of Atlanta, Chris Foote, and Paul Willen, FederalrnReserve Bank of Boston, recently published their paper, The Seductive but Flawed Logic of Principal Reduction, in thernAtlanta Fed banks’ Real Estate Research Blog. </p

The idea that a reduction program would cure housing ills has been kicking around sincernthe crisis began and there are now rumors that the administration and states’rnattorneys general may soon announce a settlement agreement that will require lendersrnto write down principal balances on troubled loans by as much as $25 billion. Policyrnwonks, the article says, will probably greet this with glee, but are theyrnright?  The authors don’t think so.</p

The idea of principal reduction is correct at its heart: borrowers withrnpositive equity rarely lose their homes to foreclosure.  If financial difficulties occur the borrower sellsrnthe home rather than default so foreclosures are rare in normal times when homernprices are rising normally. Today, however many homeowners don’t have thisrnoption. Therefore it follows that getting everyone back into positive-equityrnterritory would end the foreclosure crisis. To do this we must inflate housernprices, a virtual impossibility, or reduce mortgage balances and it isrnestimated that underwater borrowers owe almost a trillion dollars more thanrntheir homes are worth.  So who pays? </p

The “wonks” believe that principal reduction is a no-cost answer.</bThey argue that foreclosure allows lenders to recover only the current value of thernhouse, which may be far less because of a protracted delinquency period whererninterest is lost, foreclosure expenses, the physical deterioration of thernproperty, holding and selling costs, etc.  Reducing the principal balance to equal thernhouse value guarantees the lender at least that amount because the borrower nowrnhas positive equity and "research shows that borrowers with positivernequity don't default."   For example, if the borrower owes $150,000 onrna $100,000 house and the lender forecloses he might collect, after costs, $50,000.rnHowever, if the lender writes principal down to $95,000, it will collectrn$95,000 because the borrower now has positive equity and won't default on thernmortgage.  </p

One flaw in this is a misreading of the underlying economic theory: we shouldn’t automatically assume that borrowers with negative equity will always default. What if there are two borrowers owingrn$150,000; and one prefers not to default and eventually pays off the loan.  If both loans are written down the lenderrnwill collect $190,000 ($95,000 from each borrower) but if the lender doesrnnothing it will eventually collect $50K from a foreclosure and the fullrn$150,000 from the non-defaulting homeowner. rn   </p

So, the optimal policy is to offer principal reduction to one borrowerrnand not the other. This requires the lender to perfectly identify the borrowerrnwho will pay and the borrower who won’t. “Given that there is a $55,000rnprincipal reduction at stake here, the borrower who intends to repay has arnstrong incentive to make him- or herself look like the borrower who won’t!”rn</p

The authors say this identification issue is a problem oftenrnencountered with public policy as planners need to implement the policy beforernthey know the need and that always raises the cost.  While they were initially supportive ofrnprincipal-reduction plans, they began to have doubts when they could find nornevidence that any lender was actually reducing principal. This was widelyrnblamed on legal issues related to mortgage securitization, but the incidence ofrnprincipal reduction was so low that it was clear that securitization alonerncould not be even a significant part of the problem. </p

The three economists who published this commentary say they are not ignoring research that indicates negative equity asrnthe best predictor of foreclosure; indeed they are responsible for some of it.  However what the research does not show isrnthat not all people with negative equity will lose their homes, just are morernlikely to do so.  They liken it to thernrelationship between cholesterol and heart attacks – the former dramaticallyrnincreases the incidence of the latter but the majority of people with highrncholesterol do not have heart attacks, in the short or long term. </p

The highest risk loans – those made to borrowers with problematicrncredit and little equity to begin with and located in areas with dramatic pricerndeclines, are quite rare now, most have already defaulted and beenrnforeclosed.  In addition, the principalrnreductions required to give such borrowers positive equity are so large thatrnthe $20-25 billion figure mentioned in the rumored program would prevent toornfew foreclosures to make more than a small dent in the problem.</p

Ultimately the reason principal reduction doesn’t work is whatrneconomists call asymmetric information: only the borrowers have all therninformation about whether they really can or want to repay their mortgages. Onlyrnif lenders really knew exactly who was going to default and who wasn’t, could allrnforeclosures be profitably prevented using principal reduction. </p

It also must not be ignored that borrowers often control the variablesrnthat lenders use to identify likely defaulting borrowers. For example manyrnprograms require borrowers to be delinquent to get assistance.  This seems logical – we want to help thosernwho actually need help – but it is tempting for a borrower to miss a couple ofrnpayments to qualify for a generous reduction in debt. </p

The article concludes that the argument for principal reduction dependsrnon superhuman levels of foresight among lenders as well as honest behavior byrnthe borrowers who do not need assistance. rn  The limited success of existing modificationrnprograms should make us question the validity of these assumptions. “Therernare likely good reasons for the lack of principal reduction efforts on the partrnof lenders thus far in this crisis that are related to the above discussion, sornthe claim that such efforts constitute a win-win solution should, at the veryrnleast, be met with a healthy dose of skepticism by policymakers.” </p

From MND’s point of view, this tells us a few things. The major observation we take away from this research is there must be an open line of communication between borrowers and loan servicers/lenders. Second, it implies the road ahead for housing will be long and rocky. It’s going to take focused attention from specialized loss mitigation counselors to determine the fate of each delinquent loan and underwater mortgage. That will take much time and energy. </p

Special Servicers More Motivated to Mitigate Housing Losses

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About the Author


Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.

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