Principal writedowns of the day, mortgage edition

By Felix Salmon
March 23, 2012

It’s principal-writedown day today! Jesse Eisinger has uncovered a huge story: that internal analyses at both Fannie Mae and Freddie Mac show that reducing principal on troubled mortgages has a “positive net present value”. That of course directly contradicts the testimony of Frannie’s regulator, Ed DeMarco — but it’s now going to be much harder for DeMarco to maintain his position that principal reductions would never help Frannie’s finances.

Meanwhile, Bank of America has launched a pilot scheme which is a variation on the theme of principal reduction. Remember that by far the most common form of principal reduction is the short sale — and it’s also the most damaging form of principal reduction, since homeowners invariably have to leave their homes when they do one. Under BofA’s new scheme, however, that’s not the case: the bank would buy the property from the homeowner, but would then immediately turn around and rent it back at a market rate.

This idea is hardly a new one. It’s known under many names, including Right to Rent, and dates back at least as far as August 2007, when it was proposed by Dean Baker. I’ve been bashing away at it for years myself, but I’d pretty much resigned myself to the idea that it wasn’t going to gain traction.

So what changed? The markets did. The WSJ’s charts show how home prices have been falling even as rents have been rising:

MI-BO156_BANKRE_NS_20120322183310.jpg

The left hand chart, here, shows why banks don’t want to foreclose: prices are still very depressed, making homes extremely hard to sell. The right hand chart, on the other hand, shows why banks might find the rental market rather attractive. Banks have no particular interest in being landlords, but if they can do right-to-rent deals with a large number of homeowners, they can bundle those deals up into a big package, and sell it off to investors searching desperately for yield. And that could make the banks much more money than trying to sell the houses off one by one.

The WSJ explains how the BofA scheme works:

Borrowers would agree to a what is known as a “deed-in-lieu” of foreclosure, where they essentially sign over ownership of the property to the lender. This is less costly to the bank and also does less damage to a borrower’s credit than a foreclosure.

In exchange, former owners would be offered one-year leases with options to renew the leases in each of the following two years at rents that the bank determines are at or below the current market price. Borrowers would have to demonstrate an ability to pay the market rent.

For example, based on a sampling of home values and rental rates in Phoenix recently, a consumer with a $250,000 mortgage and monthly payments of $1,600 could swap the house for a lease, renting the home for $900, depending on the condition of the property and the neighborhood…

Borrowers selected for the program must be at least two months past due on their mortgage and face considerable risk of foreclosure. Bank of America is reaching out to borrowers who have exhausted other alternatives to foreclosure or who haven’t responded to earlier solicitations. Homeowners with second mortgages or other liens won’t be selected.

This is a far cry from a right to rent a home that has been foreclosed, of course. All of these self-imposed rules seem silly to me: I would much rather see a scheme where BofA simply declares that anybody facing foreclosure will have the right to rent back their home from the bank at a market rate once the home is owned by the bank. If they fail to make their rent payments, then they can be evicted just like any other delinquent renter.

I’d also love to see BofA extend this scheme to include renters in houses being foreclosed. Rental homes are homes too, and people shouldn’t get kicked out, especially not if they’ve been making all their rent payments on time, just because their landlord had mortgage problems.

The real reason for this pilot scheme, I suspect, is just that BofA is very worried about its legal ability to foreclose on houses. The difference between a foreclosure and a deed-in-lieu operation like this one is that a foreclosure is involuntary on the part of the homeowner, who retains lots of legal rights. A deed-in-lieu, by contrast, is something the homeowner must agree to, and therefore doesn’t present nearly as many legal obstacles.

In any case, let’s hope that the pilot works, and is copied by other banks around the country. It’s about time.

18 comments

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Always Felix Salmon repeating the lies of NPR/ProPublica to harass Fannie and Freddie.
How can have “a positive net present value” forgiving debt?
This blog is very suspicious.

Posted by GJOA | Report as abusive

It’s quite easy to conceive of a positive *expected* NPV principal writedown after you account for possibly certain massive losses on foreclosures from doing nothing. I’m not saying that the calculus is simple, because you have to account for the probability that the loan gets back on track when you do nothing, and the probability that the modified loan ends up in foreclosure anyways. However, many believe that the calculus is worth doing, including numerous well-respected sharp-penciled mortgage-backed securities analysts.

Posted by Kiffmeister | Report as abusive

@kiffmeister
Those numerous well-respected sharp-penciled mortgage-backed securities analysts lack common sense.
Forgive debt is insane, get it?

Posted by GJOA | Report as abusive

@GJOA I’d like to see your math. Is it the moral hazard risk that concerns you? If so, I agree that it is an issue, but it can be mitigated by incorporating some form of shared appreciation into the deal. I’m surprised that few loan writedown proposals push that idea…

Posted by Kiffmeister | Report as abusive

actually this BofA thing dataes back a much further than 2007, 1930s and civil war. BofA should be shuttered for gross ineptitude (negligence). You do not need calculus or “well-respected?” MBS peopel to figure out that principle reduction was the only and best option when the mortgage scam came to light in 2007. Instead, Geithner’s banker buddies “advised” him not to because of “moral hazard” (translation bonuses and salaries would be cut). They pounded the table because they had a seat at it. The homeowner did not. The “moral hazard” is allowing trillions of bad mortgage paper to sit on a homeowners balance sheet (full notional loan amount on worthless asset? what are you taking about?) while the hawkers run free and calm “it is very complex” . Unfortunately, the only way to get them to udnerstand is to threaten them with jail time or worse – loss of income and their homes.

Posted by rfullem123 | Report as abusive

The chances that what this study says and what Eissenger claims it says are zero. I don’t understand why you keep quoting this f*uckwit.

Posted by Danny_Black | Report as abusive

My admiration for the ingenuities of the market never ceases.

We’ve had a mortgage bubble, and housing prices are still falling. But rents are rising. So let’s encourage banks to start a rent bubble! They’ll collateralize the rental units and sell CDSs to investors! Spread the risk. What could go wrong?

As long as the “desperate search for yield” is the guiding principle of this project, and if banks have no better idea how to service rental units than they did how to originate and securitize mortgages, I suspect quite a lot. Of course, the next step will be stepped up legal enforcement of leases — long, long leases.

Posted by jbernar | Report as abusive

@kiffmeister

The calculus isn’t so simple as you suggest. You must also consider the increase in new delinquencies from offering a principal writedown option. For example, one would have to be naive to think that the current programs haven’t already elevated delinquencies – start handing out principal reductions and there will be a rush to your door.

The other issue with the GSEs is how broadly will DeMarco interpret his mandate to preserve taxpayer money? Because from what I heard Freddie’s CEO say, is principal reductions may make sense for the GSEs now BECAUSE TREASURY WILL PARTIALLY PAY FOR THEM!!! Now how is that saving taxpayers money?

Then there is the issue of the mortgage insurance coverage the GSEs have on a large portion of their seriously delinquent inventory. As Laurie Goodman pointed out, it makes no sense for the GSEs to reduce principal on mortgages where they have insurance coverage against loss – why take a voluntary loss (i.e. principal writedown) when the MI is in a first loss position.

Posted by dthor | Report as abusive

“If they fail to make their rent payments, then they can be evicted just like any other delinquent renter.”

I.e. it requires a long and costly legal battle to evict them.

Depends on your state, I suppose… :)

Posted by TFF | Report as abusive

@dthor As I said before, we can mitigate the moral hazard risk with some form of shared appreciation. Without something like that, of course there’s a real risk of current underwater borrowers going delinquent to pick up the free lunch.

I agree with you, however, that GSE writedowns are a bit murkier, especially if they’re eligible for HAMP incentive payments, which perhaps they should not be for the reasons you give.

I also agree with you on your mortgage insurance point – the GSEs should writedown only when it makes expected NPV sense.

Posted by Kiffmeister | Report as abusive

Allow me to pile-on with rest of the commenters – creating a powerful financial incentive for underwater borrowers to “go delinquent” so they can claim a principal write-down is bad policy. Can bank balance sheets survive such an experience? IDTS.

Doesn’t seem like SAMs (shared appreciation …) are the solution either. As an underwater borrower, why would I agree to share future gains when I can get them all for myself by leasing a different house and taking an option to purchase – or just buying outright at the lower current value? It could work if the rent offered in exchange for the SAM deal was below market rates, but then the bank would suffer lower current rental income (the only thing that can be booked as income, and the reason banks have always shunned SAMs) as well as a principal loss. IDTS.

Posted by MrRFox | Report as abusive

@Kiffmeister
Share Appreciation model:
1-Why FnF’s shareholders have to suffer the losses and ask for taxpayer money to fund the losses. Treasury can triple the incentives to do it, but the loss still exists.
2-How can FnF realize the profit if the home value increases.
3-How to hedge the incremental risk in their books for having a long position on a new asset (appreciation of the home value) if the mortgage already had insurance. Do we eat the previous insurance?
4-FnF’s mission is not to have a long position on home values, neither help borrowers. FnF are just housing market liquidity suppliers or market-makers (role of providing countercyclical liquidity).

It’s time for a judge to explain FnF’s charters to the american people.

Posted by GJOA | Report as abusive

@GJOA As I said earlier to @dthor everything is murkier with the GSEs so I guess we just let underwater foreclosures slowly kill them off.

Posted by Kiffmeister | Report as abusive

@MrRFox you make some really good points about Sams, but does the regular underwater “Joe Blow” enter into the complex lease and option transactions you describe? I can see “investors” playing games like that but maybe the program should be designed to exclude them?

Posted by Kiffmeister | Report as abusive

I’d personally prefer Kiffmeister’s approach of letting underwater foreclosures take place, let the market find it’s bottom, and aid price discovery.

Calculating the NPV of a mortgage portfolio is fine, but from a behavioral finance perspective, we really do want to disincentivise people from thinking that if the value of a home goes up, they’ll reap the rewards, and if the value of a home goes down, the government will leap to their aid with some kind of a bailout. Principal writedowns just create profound moral hazard on the demand side.

Posted by Strych09 | Report as abusive

@ Kiffmeister, 24th – 8:28

I can think of some good incentives for borrowers to go with some kind of SAM deal with their banks on underwater loans – preservation of credit rating is probably the biggest item, assuming it’s not already too late for that; staying put in their present homes is another (leasing or buying elsewhere requires moving); below market rent should be plausible in theory as cap rates on leases are now higher (in many cases) than banks’ cost of funds/lending rates (leasing with a SAM option at below market rates could generate both more current income for the bank than a sale at current rates/prices and lower rent for the tenant than leasing in the open market).

Still, there is the balance sheet problem for the banks. Any kind of lease deal we’re talking about here requires the loan to be written down to the current value of the property of lower. Can banks really survive if all their underwater loans are written down to current FMV? Doubt it, at least without another capital infusion from some source. Hey – maybe the government could ….?

Posted by MrRFox | Report as abusive

@MrRFox @GJOA and @dthor
Thanks for the very thoughtful comments on a topic we think about a lot here at the IMF. Even though we don’t see eye to eye on everything, you’ve all given me some food for thought!

Posted by Kiffmeister | Report as abusive

http://www.calculatedriskblog.com/2012/0 3/lawler-on-possible-fannie-and-freddie. html

Some context on when it “makes financial sense” for Frannie to do principal writedowns.

Mr Salmon why, why, why do you keep quoting this guy as if he is an even vaguely serious source.

Posted by Danny_Black | Report as abusive