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:

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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.

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