When banks voluntarily do principal reductions

By Felix Salmon
July 11, 2011

The holy grail of mortgage modification is principal reduction — the only thing which gets homeowners out of negative equity hell. And one of the big questions is why it’s not more common: it seems to make sense for all concerned, given that a sensibly modified mortgage is likely to be much more profitable for a bank than forcing a homeowner into a short sale or foreclosure and trying to sell off the home in the current market.

Last week the NYT, in a front-page story, found that Chase is actually doing principal reductions — quietly, on some of the most toxic mortgages written during the subprime bubble. But the mechanism was very mysterious — for one thing, the principal reductions were being done on many mortgages which were actually current and in good standing, rather than on mortgages which were careening towards foreclosure.

Philip van Doorn followed up, and my reading of his article — he doesn’t make this explicit — is that there’s actually method to the madness here. In order for banks to offer principal reductions, two criteria need to have been met: (a) they came into the mortgages via acquisition, rather than writing them themselves; and (b) they bought the mortgages at a discount.

Wells Fargo said that even though most of the Pick-a-Pay modifications had resulted “in material payment reduction to the customer,” Wells Fargo had not been forced to make larger provisions for loan loss reserves — which would have hurt earnings results — because of the aggressive write-downs taken when the loans were acquired…

JPMorgan had $24.8 billion in option-ARMS as of March 31 within in its $70.8 billion purchased credit impaired portfolio, acquired as part of the company’s purchase of the failed Washington Mutual from the Federal Deposit Insurance Corp.in September 2008. The PCI loans were written-down to fair value when they were acquired, and as of March 31, JPMorgan said that although it had set aside $4.9 billion in loan loss reserves for all of its PCI loans, “to date, no charge-offs have been recorded on PCI loans.”

It seems that Wells and JP Morgan are happy to do principal reductions only on the mortgages they bought at a discount from Wells Fargo and WaMu respectively; Bank of America, meanwhile, which inherited a bunch of these loans when it acquired Countrywide, is not doing principal reductions, and I don’t think it’s a coincidence that the Countrywide loans were bought at very close to par.

The behavioral psychology here is very easy to understand. No bank wants to admit that it wrote idiotic loans, and write down its own assets from par. Meanwhile, it’s much easier to write up an acquired asset, if the amount you reduce the loan is less than the discount you bought the loan for in the first place.

Economically speaking, however, what the banks are doing here does not make sense. Either writing down option-ARM loans makes sense, from a P&L perspective, or it doesn’t. If it does, then the banks should do so on all their toxic loans, not just the ones they bought at a discount. And if it doesn’t, then they shouldn’t be doing so at all.

The truth is, of course, that banks should be doing principal reductions, and they should be doing them on lots of their loans, rather than just the ones they bought cheap. And the fact that they’re already doing this, entirely voluntarily, on some of their loans is the best possible indication that it makes perfect economic sense to do so on all of their loans. Even if doing so might involve admitting that the subprime crisis still isn’t fully over.


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With this of reduction how much of a hit does the borrower take on their credit score? A friend talked to his lender and got the principal reduced by a measly amount ~ $3000 but he took a massive hit on his credit score and it took him some time to build it back up.

Posted by KViswanathan | Report as abusive

Behavioral psychology may have something to do with it, but I suspect accounting rules and regulations have a lot to do with it as well. Even there, it seems odd that they would be offering reductions on mortgages that are current, unless there’s some other reason to believe they might not stay that way.

Posted by dWj | Report as abusive

Maybe I’m missing something, but it sounds like banks are renegotiating mortgages when renegotiation would result in a profit and failing to renegotiate when when it result in a loss. This essentially brings profits into the current accounting period while postponing losses until later periods.
Where’s the surprise in that?

Posted by RZ0 | Report as abusive

So, contrary to all the horror stories you hear about people not being able to get in touch with loan servicers, etc to re-neg their loans, there are people available to talk into arranging a re-neg on an out-of-house loan when it’s in JP best interest? Way to go Jamie, Benny B, Timmy G and O’bammie. You guys suck!

Posted by Woltmann | Report as abusive

Felix wrote: “It seems that Wells and JP Morgan are happy to do principal reductions only on the mortgages they bought at a discount from Wells Fargo and WaMu respectively”; think he intended to write “It seems that Wells and JP Morgan are happy to do principal reductions only on the mortgages they bought at a discount from Wachovia and WaMu respectively”.

Before that, he wrote: “And one of the big questions is why it’s not more common: it seems to make sense for all concerned, given that a sensibly modified mortgage is likely to be much more profitable for a bank than forcing a homeowner into a short sale or foreclosure and trying to sell off the home in the current market.”

It doesn’t seem at all mysterious to me why principal write downs aren’t more common: doing that invites moral hazard, first, and second penalizes people who patiently sat on the sidelines when prices were obviously spriraling into bubble territory and saved their money to afford a full 20% downpayment instead of taking out a toxic loan because otherwise they’d be “priced out forever” as real estate agents were running around trying to scare everyone into buying as soon as possible up until 2007.

From a behavioral economics perspective, if we want to have people avoid bubble-type behavior in the future, we need there to be severe penalties involved for engaging in bubble-type behavior. If everyone just thinks that they can engage in the worst type of bubble behavior and then when things go bad, they’ll be bailed out, then that constitutes exactly the wrong incentive structure.

What exactly justifies a principal reduction just because a home buyer owes more on their mortgage than the attached home is worth? A principal reduction is a bail out, pure and simple. It rewards the profligate people who took out mortgages that they couldn’t afford, and penalizes the people who waited and are still waiting patiently for the price level to reach a sustainable level with some relationship to the fundamentals. For that reason, among others, principal reductions DO NOT “make sense for all concerned”.

In order to market capitalism to work effectively, the people who engage in profligate behavior have to be punished by separating them from their assets so that assets are in the hands of those that can put them to work wisely. Foreclosures and to a certain extent short sales support this process. Principal reductions actively thwart this process.

Posted by Strych09 | Report as abusive

This is akin to the Japanese debt problems when what was then called a massive “credit overhang” developed. That was when lenders were in way too much to borrowers and they had no way to mark down the debt. Lenders tended then to make additional loans which they treated as interest payments on the debt – essentially bookkeeping lending that added to debt while creating income. A lot of this went on in the US in the S&L debacle. I hope it is not going on here now because that would be very bad.

We boasted we would attack the problem with market solutions, meaning we’d write down debt. We blamed Japanese cultural differences, an inability to confront, etc. Guess that was hubris. There is a huge credit overhang now.

The best news in this post, Felix, is the balance sheet effects of writing down mortgages bought at discount. For example, it allows creation of a “good bank / bad bank” like with the S&L’s. The bank then has a portfolio of good loans and it can segregate the bad and maybe spin it off into some market which prices recovery values.

Posted by jomiku | Report as abusive

Fascinating post.

I think I agree with RZ0. The renegotiation brings a current profit to the bank.

Still, this is a fascinating example of the profit-driven manipulation of information asymmetry in order to get around the problem of moral hazard.

Since the people who are getting the offers don’t know why the bank is offering to renegotiate the mortgage (i.e. they don’t know the discounted price paid for their original loan), they are less tempted to threaten default or to bargain. The bank shows them only the current valuation of their home in relation to their original mortgage and income. It doesn’t have to offer to renegotiate underwater mortgages if the income of the homeowner is judged sufficient to continue to pay. (It can probably rely on fear of damaged credit for that.)

Thanks to your post, these homeowners now know. If they read it, their bargaining position is stronger because they know the bank is still capable of making a profit. In fact, any homeowner whose original mortgage was with Washington Mutual or Wachovia now knows it. They should now initiate renegotiation!

You have helped to redress the balance of moral hazard! Thank you, Felix.

Posted by jbernar | Report as abusive

Thanks for touching on this Felix. I have some questions.

Being banks are not voluntarily doing favours for any homeowners (they even abused HAMP)perhaps there are other reasons the banks are being quiet and so very “generous” as they pick and choose. Remember the banks have been doing this for some time. ( I referenced banks doing this during the Foreclosuregate/HAMP discussions)

What better way to get toxic loans off their books and to mend chain of title and securitization issues than to restructure the mortgages so a forensic audit only sees the “fix”?

Being many of the people who sought the option arm mortgage payments were speculators, flippers, money launderers, cashout kings and fraudulent appraisers, doesn’t that mean the banks are rewarding those who ripped off banks and taxpayers and helped create the bubble rather than responsible homeowners?

For anyone who still thinks this is great for howmowners, remember that one of the people helped with her home mortgage was an investment realtor who used option ARMs on her other investment properties too. How many people were helped more than once?

The people who bought option arm mortgages were those who paid the least and often were allowed to not make payments at all, yet they are being helped. Why were those who put 20% down, lived within their means and continuously made payments until they became sick or laid off not helped with their mortgages, but foreclosed upon instead?

This will not necessarily be helpful for the economy. Homeowners who feel ripped off might be more inclined to say f’it and walk away or declare bankruptcy. Even the most moral and ethical can become fed up when they are being ripped off because they remain good and pay their mortgages responsibly while the bad are rewarded.

Are Credit Unions booming there yet? I can’t see how people can trust the TBTF banks after seeing how fraudulently they operate.

Last question. Are taxpayers paying for this through some back door Government subsidies?

Posted by hsvkitty | Report as abusive

howmowners = homeowners

Posted by hsvkitty | Report as abusive

People who owe more on their mortgages than the home is worth and therefore feel entitled to a mortgage modification = home moaners

Posted by Strych09 | Report as abusive

I also think RZ0 is spot on. Banks consider principal writedowns as a matter of last resort. Banks are fighting to build their capital ratios back up and so postponing losses is desirable if they can get regulators to pass of on them.

Even more imporntantly they need mods to release the presssure of bad debts slowly and quietly so that the trickle does not become a flood that would swamp them with losses.

Posted by y2kurtus | Report as abusive

Whenever a financial company does something that on the surface appears to make little or no economic sense you can be 99.99999999999999999% certain it is due to regulation, be it capital requirement, tax, accounting or otherwise.

What immediately leaps to mind is that when JP bought the loans they were probably valued at close to zero as ARMs were defaulting all over the place and that was expected to accelerate. Thanks to ultra-low interest rates that armegeddon hasn’t come to pass. So those loans will be valued at a higher level than before and JP is simply cashing in that profit – remember when they remortgage as far as the bank is concerned that old loan was paid off in full and now there is a new higher quality asset on the books. I suspect as well that the loss provisioning and cap reserves needed to be put aside for the new mortgages is lower than ARMs and these new mortgages might be eligible for securitisation through Freddie and Fannie whereas i believe ARMs are not. BoA bought their loans closer to par and so have no incentive to realise those losses and might as well roll the dice. Remember also it is the NPV that is the value on the balance sheet not the principal, so if reducing the principle increases the NPV it makes sense for the bank to do it. I suspect the rate on the mod mortgages is higher.

One thing I think we can virtually certain of is that none of the explanations of either hsvkitty nor jbernar are even remotely connected to the real reason – yes i know, the idea these two would be talking out their backsides is truly shocking! jbernar, the article says that the bank is explicitly offering mods to people who are in good standing. Maybe you would look less silly if focused on the facts and little less on buzzwords whose meanings you clearly have no understanding of.

hsvkitty, maybe i missed all those incisive, intelligent posts you made because virtually every you linked said either the very opposite of what you claimed or was written by some clueless tosser – cough Cullen Roche, cough Yves Smith. As for the “issues” with the note and the meltdown of the RMBS market that financial “journalists” were predicting last year, it never came to pass. There is simply nothing to fix. Am also loving the faux outrage about ARM mortgagees. Anyone who has defaulted on a loan has not lived within his means, end of story and obviously as a retard you think bankruptcy and losing your home is an “easy option”.

Posted by Danny_Black | Report as abusive

@Danny Black, everyone is clueless but… you? That you would always find a reason to back up the banks is laughable but of course expected, given your “background” as a snotty, elitist, bank apologist repeating your own brand of “I am right because I said so and I would know as I used to work for a bank” throughout the web without providing URLs to back it up.

The couple of times I added URLs that did not specifically speak to the question, that you had to actually read through to get the gist, or find you wished to hear is better than never adding any URLs to back up your pontification, Danny Black …

One thing I can guarantee is I am probably much closer to the truth than you could ever be. You are in denial that banks are too big, that Goldman ever did anything wrong or that there could possibly be something evil going on like foreclosure-gate and robo-signers. You deny it even when it smacks you in the face as it has done time and time again.

The mortgages were only “in good standing” because they barely made a payment and hardly dented the mortgage. The banks knew that some of these would likely blow up once the interests rates came back up, or resets occurred, which is more likely to happen, so please stop pretending you don’t know that.

This type of shoddy mortgage should never have been issued in the first place, so please, stop backing up banks. Should taxpayer money be used to help bail out crooks and flippers, it would be another disgusting travesty! Are you actually denying that many of the people who bought those mortgages were scumbags and flippers? I will gladly admit that the banks happily sold the teaser rates to unsuspecting poorer people as well, but I am sure those homes are long foreclosed upon.

Anyone who has defaulted on a loan has not lived within his means? How about those who did, yet became ill or lost their job. No pity from you eh? Yes there was no pity for those who were longtime homeowners who just wanted a house over their heads. Yet it is ok banks help these people who are likely not even homeowners, but realty investors and con-men. No need to answer. I know where your heart is …

The issues with the note did come to pass, but were so expensive and retarding (proper use of the word BTW)for the court system that those involved have thrown up their hands rather than follow rule of law. The AGS found so many problems with banks, servisers, the court system, the chain of title and fraudulent documents, MERS, ETC that they knew it would grind the housing/mortgage industry to a halt and they were literally stymied.

Stop pretending there wasn’t anything to it all, because all of those problems still exist and are affecting the housing market and will for some time, which is why I suspect the banks have been trying to quietly clean up the mess before they are investigated. I guess you would know that if you actually read my URLS.

PS: Calling people retarded is offensive slang and is not acceptable and hasn’t been for some time and I doubt your excuse that you are British will give you much of an out for using it…

Posted by hsvkitty | Report as abusive

I’m puzzled by the personal nature of Danny Black’s response to my post that was not specifically directed at him.

Right or wrong, nothing I wrote implied that the mortgages were not currently in good standing. But the banks must have some cause for concern in order to consider a loan modification, no? The one piece of information they lack for any mortgage in good standing is the current income of the homeowner, i.e. his ability to fulfill the terms. This information they may obtain if they offer the possibility of a modification. Then they can choose whether or not to modify, and if so, by how much.

Posted by jbernar | Report as abusive

If the principal write down is so offensive, and costly to the public, yet the economy continues to slide into oblivion, what is the cost to the public, and/or government to bring back the chapter 13 cramdown? I find it ludicrous that a vacation home can be crammed down, it should only be your principal residence. It is the homeowner taking the hit on their credit, and 5 years of repayment. They also have to qualify to even file for chapter 13. Someone please tell me why this is not a good idea? President Obama promised that he would bring it back, why is it being ignored?

Posted by cfraser | Report as abusive

hsvkitty, calling you retarded is a compliment.

Posted by Danny_Black | Report as abusive

jbernar, I read another one of your posts i thought was silly and frankly responded to you after reading yet another spastic comment from hsvkitty which did not put me in a polite frame of mind.

I suspect it is more simple than the round about explanation you gave. ARMs trade for far less than more standard mortgages and I suspect especially now given it is the GSEs that are propping up the market. An example is that say there is an ARM for 100,000USD. JP buys it for 20,000 because of highly distressed market conditions. Lets say because of market condition improvement it goes up to 30,000. If i have a standard mortgage on the same property I can sell it via a GSE for 70,000 so I offer a 10k discount to move to that standard mortgage and it is still worth more than the old ARM. I would guess this is an explanation. I say guess because I didn’t work in mortgages and I am not in the market for a while but I can pretty much guarantee it is being driven by regulation and not some logical economical reasoning as you seem to imply. As for bargaining, the homeowner is being offered some free cash plus he is no longer taking a highly leveraged bet on interest rate movements. Seems like a good deal for everyone.

The only possible taxpayer subsidies i can see are maybe via FDIC when the banks was sold to JP – but my very limited understanding is that FDIC is funded by insurance payments by banks – and via the implicit subsidy that Freddie and Fannie might be giving in the secondary market.

Hope that is a politer answer.

Posted by Danny_Black | Report as abusive

I also would like to know, why would BofA buy Countrywide loans at almost par, when the other banks paid significantly less? It does not make business sense they would pay more than pennies on the dollar for these toxic loans from a bank going under.

Posted by cfraser | Report as abusive

I also would like to know, why would BofA buy Countrywide loans at almost par, when the other banks paid significantly less? It does not make business sense they would pay more than pennies on the dollar for these toxic loans from a bank going under.

Posted by cfraser | Report as abusive

cfraser, bought at different times. WaMu was sold by FDIC in the very depths of the credit crisis. Countrywide was bought just before everything kicked off and was an independent company when it sold itself. There is of course a difference in IQ between the then CEO of BofA and current CEO of JP.

Posted by Danny_Black | Report as abusive

@jbernar, Do not be puzzled. Simply know Danny_Black was a bankster until 5 years ago and his fatcat ego still gets the better of him. If he cannot make a valid point, he resorts to making derogatory slurs instead.

Posted by hsvkitty | Report as abusive

I am going to repeat what I said earlier because it bothers me that the banks reward those who created the inflated housing market and bubble.

“Being many of the people who sought the option arm mortgage payments were speculators, flippers, money launderers, cashout kings and fraudulent appraisers, doesn’t that mean the banks are rewarding those who ripped off banks and taxpayers and helped create the bubble rather than responsible homeowners?”

Posted by hsvkitty | Report as abusive

hsvkitty, whereas you link to articles that say the opposite of what your claim.

Failing that you link to people like Cullan Roche who worked for ML – aka the Dumb Money – selling high-commision junk to widows and orphans whilst waiting to take up residence in the circle of hell below pedophiles that people broking to the “mass-affluent” go to when they die. Having failed to get a job at BoA – aka the even Dumber Money – he now tells the world how you should trust him with your money – for a reasonable commission of course – rather than those horrible banks. Or to Mr Garfield who by dint of his family got to work at a bucket shop several decades ago – aka he is an “ex-investment banker” – who if he ever dealt with anything more complex than an index future i will go out buy a hat and eat it. Having founded some mickey mouse leasing firms – aka “sitting on boards of several financial companies” – he has spotted a way to make money scamming people who are struggling to stay in their homes by offering to burn the last their last remaining bits of cash on “training” on how to put off the inevitable. Or maybe Yves Smith, having worked at a fourth rate bank running Team Xerox, she suddenly discovers that if she screams bankster loud enough she gets a ton of ad revenue and sells books. By your friends they will know you…..

Posted by Danny_Black | Report as abusive

He Danny_Black, by your words we all know you. By your denial we know you. By your attempts to belittle me, I know you.

You do not even attempt to back up your claims. You spew your derogatory remarks and then leave, smug that you might have riled another human and defended the banks. Big whoop, Danny.

Meanwhile foreclosuregate is very real, servicer fraud and abuse is very real, false documentation and lack of legal process is real and yet is still bogging down the system and delaying a return to market balance for the housing industry.

But you blame the people, because you are a former banker and do not want your reputation tarnished and are in denial.

You said earlier that the banks are doing this because of regulation. Well of course they are. Some banks will do anything to get around the law… regardless of ethics and even their own codes of ethics. Helping out the people who needed and deserved the mods and not abusing HAMP would have been the right thing to do.

But banks had all the MERS, illegal titles and illegal documentation mess to hide, so there had to be more lies and foreclosures. You can deny it all you please, but it is real.

Posted by hsvkitty | Report as abusive

When a significant concession on a loan (eg: principal forgiveness) is granted to a borrower in financial difficulty, there is a special kind of accounting hell into which that loan falls, known as Troubled Debt Restructuring. The compliance costs, not to mention the disclosures that investors get to see, with these loans are significant. Furthermore, any “TDR” requires substantial additional reserve testing that can inflate current expenses.

It is also hard to say that a principal modification will resolve the underlying issue with many of these toxic assets, which is inability to pay. If the bank is willing to take the hit on a principal write-down, there is little reason why a short sale is not a more appealing option.

As for the comment about “writing up” an asset, I don’t believe the accounting works that way. Discounts on loans acquired must be amortized over the remaining life of the loan (as adjusted for prepayments, etc). A write-down to principal would not inflate the bottom line, but rather would close the gap between the discounted (book) value, and the par (principal) value. A write-off is still a write-off.

further reading:

http://www.primaticsfinancial.com/upload s/HFILoan%20Accounting_FinalEEI.pdf

Posted by DLSabo | Report as abusive

hsvkitty, just keep repeating it to yourself. Keep posting links that say the opposite of what you claim. Keep spouting nonsense that show just thick and ignorant you really are.

Posted by Danny_Black | Report as abusive

Danny_Black, please keep bloviating like the former bankster and bank apologist that you are …

Where are your links? Oh yes, who needs them when you are a pompous jerk who thinks selling the junk that caused the economic crisis makes you an expert at just about everything.

And so you jump on any anti bank comments to assure the world that banks are always to be trusted … and therefore, so is anything you say… but I have long ago seen you are full of “it” and like to spread it around.

Posted by hsvkitty | Report as abusive

What is the most comical about this ideology is that Bank of America even has pages posted on their website about doing “principal reductions” if your loan was originally from Countrywide. If you are in a negative ARM loan and if you have more than 20% negative equity. It makes NO SENSE at all why bank would not consider this at the largest level! I am in real estate and do a lot of short sales and the hundreds of thousands of dollars the banks lose on short sales and foreclosures is far more than what they would lose by writing down the mortgage. It is complete stupidity!

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