Loan Mods: Are Principal Reductions the Solution?by Tim Manni
The mere suggestion of this concept is bound to envelope two schools of thought, two sets of strictly-opposing opinions. While some readers may interpret principal reductions as a glimmer of hope that’s long overdue — a solution that may keep some from failing on their mortgage — others are bound to gnash their teeth in disfavor, another home-retention strategy that only serves to soften the consequences of falling behind on your mortgage.
Principal Reduction — when a lender or a servicer reduces the total amount that you owe on your home loan — has long been viewed as a modification strategy of last resort. However, due to the ongoing failure of the home affordable modification program (HAMP) — with its minimal permanent mods, high re-default rates, etc. — and the ongoing issues of falling home prices and rising foreclosures, the chatter that’s calling for principal reductions (especially in the hardest-hit housing markets) has become louder. That being said, there’s another group who wants to avoid the use of principal reductions like the plague, since they are viewed as a reward for failure.
Note: the goal of all modification efforts is to prevent foreclosures keep borrowers in their homes. Furthermore, the main culprit driving borrowers to walk away, or strategically default, is negative equity — when your home is worth less than what you still owe on it. Strategic defaulters tend to be borrowers who can technically still afford to make their monthly payments, but their homes are so far underwater that they decide that it’s not worth it — it all comes down to the desire to pay, not the ability to pay.
In a recent issue of Servicing Management Magazine, Sue Allon, CEO of Allonhill — a “mortgage due diligence and credit risk management” firm — suggests principal reductions as a strategy that could improve success for servicers. “Principal reduction programs are undoubtedly called for, and will emerge and take shape over the next few months.”
Conversely, we talked to an employee in the mortgage servicing department of a Michigan credit union who says “We are definitely trying to stay away from principal reductions. I think you can get where you need to be without them.”
Whether you agree with principal reductions or not, what HAMP doesn’t address is that loan modifications are not a one-size-fits-all solution. The loan mod programs that we’ve examined that seem to have the greatest success rate (better than HAMP at least) seem to a) bring borrower and lender and/or servicer face to face, and b) determine what exactly is causing the financial hardship and develop a strategy to solve it, something HAMP doesn’t do. The person we spoke with at the credit union told us that the attitude in their office is that “If the borrower has a willingness to keep the house, we have a program for them.”
Principal Reduction Wheels Already in Motion
Given the pros and cons, the advocates and critics, can or should we expect principal reductions to catch on? Apparently so.
Just this morning, Nick Timiraos and James Hagerty of the Wall Street Journal reported that Bank of America will soon begin to reduce the principal on troubled loans by as much as 30%:
The plan is one of the boldest moves yet to address the plight of millions of U.S. homeowners who are “under water,” owing more on their homes than they’re worth. It could make it easier for the Obama administration to move in a similar direction with its existing loan-modification program, although senior government officials and many bankers remain very wary of offering to cut loan balances as the main way of helping distressed borrowers.
The bank’s move is part of an agreement to settle claims over certain high-risk loans made by Countrywide Financial, which the bank acquired in mid-2008. The Massachusetts Attorney General’s office, which was negotiating with the bank, said it was prepared to file suit had the agreement not included principal reductions.
Changing American Attitudes?
Many fear that principal reductions will further the sense of entitlement among borrowers, and diminish the consequences of falling behind on your mortgage.
“People are saying, ‘[Strategic defaults are] purely an economic decision; if I don’t get a reduction in principal, then my home is a burden, not an investment,’” said Allon. “This sounds like the next phase of American entitlement syndrome…now they think ‘I am entitled to money back if my house turned out not to be a good investment.’”
Inevitable in the “Big Four?”
Even our contact at the credit union admits that principal reductions may be unavoidable in the hardest hit markets (mainly California, Nevada, Florida and Arizona) where home prices have declined the most. According to the Office of the Comptroller of the Currency, modified loans which have had their principals reduced perform much better over the long term.
Strategic defaults have unfortunately spawned the modification strategy of principal reductions as lenders and servicers strive to keep borrowers in their homes. Would the debate over principal reductions exist if borrowers hadn’t started walking away? We don’t know. But negative equity has created such a problem for American homeowners that there may be no other way to solve it.