Principal reductions begin in earnest

May 9, 2012
This is an important milestone, even if it's too little, too late:

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This is an important milestone, even if it’s too little, too late:

Bank of America Home Loans has begun reaching out to customers who may be eligible for forgiveness of a portion of the principal balance on their mortgage under terms of a recent settlement…

The bank estimates average monthly savings of 30 percent on mortgage payments of customers who qualify for this program…

Bank of America actually began making principal reduction offers under the program guidelines in March, initially concentrating on homeowners who were already in the modification review process. So far under this early initiative, about 5,000 trial modification offers have been mailed, providing a potential total of more than $700 million in forgiven principal. Homeowners are required to make at least three timely payments before the modification can become permanent.

On average, the principal reduction being offered is substantial: it’s on the order of $150,000. And this offer is being extended to some 200,000 homeowners, which means we’re talking a lot of mortgage principal here: some $30 billion.

In reality, however, the actual amount of principal forgiven by BofA is likely to be much smaller than that. As we’ve seen with HAMP, banks are incredibly good at putting people into three month trials, and then managing to determine that for whatever reason they don’t qualify for conversion to permanent modification. What’s more, ironically, many homeowners might not be able to afford to accept this principal reduction, since after the end of this year, forgiven principal will count as income, for income-tax purposes, and the income tax on $150,000 of windfall income is substantial.

Still, principal reduction is exactly what the country needs right now, and I’m glad that it’s finally beginning to happen. I wrote about the subject in The Occupy Handbook, and this seems as good a time as any to put my chapter up online. So here goes.

There’s a lot of blame to go around when it comes to the causes of the financial crisis, but at heart, it was about debt — or, as the the financial markets like to call it, leverage. Investment banks created highly leveraged mortgage-backed securities that blew up; commercial banks backed up their holdings of super-senior debt instruments with little or no capital; homeowners bought houses with no money down, paying for them by borrowing amounts they could never afford to repay.

In many ways, the debt-fueled housing bubble was the financialization of America carried to its logical conclusion. From the early 1980s onward, economic growth was increasingly a function of leverage: small improvements amplified by being turbocharged with debt. A little debt can do wonders for growth — but like a drug addict, the economy eventually needs that much debt just to stand still, and ends up having to take on more and more leverage to sustain the growth it’s used to.

With leverage, of course, comes danger — what finance types call “systemic risk.” If the debt stops getting rolled over, as happened in 2007, then the entire economy can come to a screeching halt, with the loss of trillions of dollars in wealth, not to mention millions of jobs across the country. When the party stops, as happened in 2008, a new word enters the lexicon: deleveraging. It’s a central paradox of finance: while the economy needs credit in order to grow and to create jobs, it also needs to reduce the total amount of debt outstanding, in order to reduce not only individual and corporate debt burdens but also the risk of another massive crunch.

Deleveraging is always a painful process. When done on a nationwide scale, it often takes the form of inflation, which tends to hurt the poorest members of society in a particularly invidious way. When done on a case-by-case basis, it involves the loss of a lot of wealth. After all, your liability is my asset. (The money in your checking account, for instance, is counted toward your bank’s total liabilities. If your bank repudiated your claim to that money, then it would be richer, but you would be poorer.) Nevertheless, deleveraging is necessary. And every so often, it’s possible to find a positive-sum way of making it happen: a plan that makes everybody better off.

How can writing down debts ever benefit a creditor, the person to whom those debts are owed? The answer lies in the fact that if a debt is not going to get paid off in full anyway, the creditor’s best interest lies in simply maximizing the value of what he does end up receiving. Let’s say you owe me $1,000 — but then you come and tell me that you can’t afford to pay me back. You’re faced with a choice. Either you empty out your checking account and I take everything in it, which is $250, or you can find some money elsewhere and give me $450 in settlement of the debt. If I’m sensible, I’ll take the $450 — and I’ll leave you with a working checking account.

Compared to the $1,000 I had in the first place, I’m worse off, but that’s a sunk cost at this point, and there’s no point crying over spilled milk. I have to face the situation as I find it today, and make the best of it.

You’d think that banks, in particular, would be alive to the sunk-cost fallacy — partly because denial is a pretty bad business strategy at the best of times and partly because they all worship at the altar of something called “mark to market.” That is, they check to see what their loans are worth every day (or at least every quarter) and then value the loans at what they’re worth in the real world rather than how much was borrowed in the first place. Yet banks — and this probably comes as little surprise, at this point — can and do behave in surprisingly irrational and childish ways. A lot of the time, especially when it comes to dealing with homeowners, they seem more interested in inflicting misery than in maximizing their own financial returns.

All of this comes into starkest focus with respect to mortgages. America has millions of underwater homeowners, many of whom are behind on their payments and all of whom are significantly less likely to pay off their mortgage in full than they would be if they actually had equity in their houses.

It’s simple logic, used by every company and commercial real estate operation in the land. If you owe more than your property is worth, and you can walk away from that property and discharge your debt in full, then you should absolutely do so: indeed, the Mortgage Bankers Association did exactly that in 2010. It had a $75 million mortgage on its Washington, D.C., headquarters but sold the building for $41 million, moved out, and is renting elsewhere, relieved of the burden of $75 million in debt.

Banks hate it when people walk away from their homes. (The act is often called “jingle mail,” because you’re essentially mailing in your keys to the bank.) At the same time, they’re often enormously reluctant to do the one thing that is completely effective at preventing people from doing that, which is to reduce the principal due on the mortgage so that the amount of the mortgage is lower than the value of the home. The US government, too, has been reluctant to push this as a solution: its attempts to encourage banks to refinance mortgages have all been centered on reducing monthly mortgage payments rather than the total amount owed. In fact, many government-backed mortgage modifications actually increase the total principal amount because of various fees tacked on during the modification process.

Even if your mortgage payments go down, it can still make all the financial sense in the world to stop paying them, especially if you run into trouble. If you can rent a nice place for less than your mortgage payments, and if you have no real prospect of owning any positive equity in your home for the foreseeable future, it makes sense to free up a lot of cash flow by just stopping payments on your house. This is especially true when banks can take well over a year even to start foreclosure proceedings.

The result is a huge “shadow inventory” of homes overhanging the market. These homes aren’t yet for sale but will at some point get sold in a foreclosure sale, depressing values across the neighborhood. As a result, in 2011, no one wanted to buy — and house prices continued to fall, despite record low mortgage rates of less than 4 percent.

So what should happen when people get into trouble making their mortgage payments on a house that is underwater? After 2008, banks tended to do one of two things. They waited for an interminable amount of time, then initiated foreclosure proceedings and kicked the family out of their home. Alternatively, they worked out a mortgage modification that didn’t reduce the amount owed by a single dollar, thereby maximizing the probability of a redefault and of the homeowner’s having to go through the same painful process all over again.

There are multiple ways of doing this better. The simplest is just for the banks to unilaterally reduce the principal amount owed on a mortgage. It’s much more effective, always, for a bank to reduce principal and keep the interest rate constant than it is to do what they tended to do after 2008, which was to keep the principal constant and reduce the interest rate. Why don’t they reduce principal? They don’t because doing so involves writing down the value of the mortgage on their books — something they’re bound to do sooner or later, but which they’d much rather do later than sooner.

As the depressed stock prices of every bank in America in 2011 attested, however, no one really believed the values that the banks put on their mortgages — they weren’t kidding anyone. Coming clean on the true value of their mortgage portfolio might hurt banks’ quarterly earnings, but it wouldn’t necessarily hurt their share price. Once the mortgages are marked down to a reasonable level, banks can be much more sensible about how they’re going to deal with homeowners in difficulty.

There are circumstances in which banks have shown themselves willing to take losses on the mortgages they own. One is when they sell a big portfolio of mortgages to some third-party investor: such portfolios are often sold at just 10 percent or 20 percent of the face value of the mortgages if a lot of those mortgages are in default. Another scenario, and it happens pretty frequently, is the short sale, in which a homeowner sells a house and hands over all the proceeds to the bank, and in turn the bank writes off the mortgage, even though it isn’t fully paid off. Then, of course, there’s the worst scenario of all: you fall behind on your mortgage, and the bank forecloses on your property, taking over the deed to the house. At that point, the bank will turn around and sell the property, almost certainly for less money than it was owed on the mortgage, and take a loss.

All of these mechanisms open up possibilities for keeping homeowners in their homes, even after they’ve fallen behind on their mortgage payments: you just need a little imagination. For instance, let’s say you’re a bank that has foreclosed on a home. Standard operating procedure in such a situation is normally to kick the occupants out, put the house up for auction, and take whatever you can get for it. But there’s no rule saying you have to do that; indeed, there’s no rule saying that you have to evict the home’s occupants at all. Instead, why not rent the house back to them at the market rate? The market rent will almost certainly be lower than what they used to have to pay in mortgage payments, and at the same time you get to avoid kicking the family out of their home. Everybody wins in this case. The family gets to stay where they are, the neighborhood isn’t blighted by a boarded-up home being sold at auction by an owner who doesn’t care about it, and the bank gets a healthy income stream rather than a modest sale price.

And if the bank prefers to get cash rather than be a landlord? No problem: it can simply sell the property to someone happy to rent it out to the current occupants. Many such organizations and individuals exist: in days of record low interest rates, people with money often jump at the opportunity to make a decent rental yield on their investment, especially if they’re helping out a family in straitened circumstances at the same time. Often, such a rental contract will include a clause allowing the former owners to buy the house back at a pre-set price: the new owner might ask for a 10 percent profit after one year, a 15 percent profit after two years, and so on. If the family members manage to qualify for a mortgage to buy their house back, then the new owner will sell it to them — for less than the occupants originally paid but more than the new owner/landlord paid. Again, everybody wins.

Similarly, if a bank sells a defaulted mortgage for a fraction of its face value, then there are lots of ways in which the new owner can keep the former homeowners in their house and still make money. The principal amount can be reduced, of course, as can interest payments — and you probably wouldn’t be surprised to learn how much simple and sympathetic human contact can help.

Most of the time, homeowners have no ability to get through to a sensible human being at their mortgage company who can understand what they’re saying and make empowered decisions with regard to any possible mortgage modification. Instead, they get the standard run-around: they’re constantly being asked to fax in documents that always seem to then go missing. By contrast, if you buy a mortgage and approach the homeowner with good will and a genuine desire to find a reasonable solution, it’s amazing how often something mutually beneficial can be worked out. Indeed, a company called American Homeowner Preservation (AHP) is doing just that: it’s set up a hedge fund devoted to buying pools of defaulted mortgages and keeping the homeowners in their homes, and it is making good money doing so. All it takes, really, is a little bit of compassion and an ability to be inventive — rather than following exactly the same script every time.

AHP started with a simpler, nonprofit model: it would act as a broker, putting together willing buyers with underwater homeowners. The homeowners would do a short sale to the buyers at the home’s market value, and the buyers would lease the house back with an option to repurchase. That model didn’t work, because the banks refused to cooperate. While they were okay with short sales in general, they were emphatically not okay with any short sale that involved sellers remaining in their home. Tired of fighting and losing endless battles with the banks, AHP decided it would be a lot easier to buy the mortgages themselves. That way, AHP didn’t have to deal with impenetrable and illogical bureaucracies all day.

The banks have a reason for making it hard for people to sell their homes and stay in them regardless: they’re worried that lots of other homeowners will attempt the same stunt. However, it only makes sense to sell your house if you’re significantly underwater on your mortgage. And if you’re significantly underwater on your mortgage, then it probably makes sense to sell your house whether you get to stay in it or not.

Indeed, one of the more evil tricks of America’s banks is that the very people who need the most help with their mortgages — people who are far underwater — are also the people least likely to be able to get it. If you bought your home at the top of the market and it’s now worth a lot less than you borrowed to buy it, you’ll probably be rejected for the kind of mortgage refinance that everybody else can get with no difficulty. As a result, if you’re current on your underwater mortgage, banks and investors reckon that mortgage is worth not less than par (because it’s underwater) but, rather, more than par — about 106 cents on the dollar, on average. On a $200,000 mortgage, investors will pay a $12,000 premium just to be able to collect your high-interest mortgage payments, which you can’t reduce because you’re not allowed to refinance.

It’s a little bit crazy: if these homeowners were rational, especially if they live in a nonrecourse state like California, they would just mail their keys in to their bank and be done. That’s certainly what the bank would do, in the same situation. (In 2009, for instance, Morgan Stanley mailed back the keys to five San Francisco office buildings worth $1.5 billion rather than pay the mortgage on those buildings out of its record profits that year.)

Instead of reacting with gratitude to the fact that these underwater homeowners are paying their mortgages in full, though, banks punish those homeowners by forcing them to continue paying the high interest rates they locked in at when they bought at the top of the market. Mortgage rates had never been lower than they were in 2011, which meant that mortgages that couldn’t be refinanced to a lower rate were particularly valuable to banks.

If you’re current on your mortgage, the banks won’t let you refinance, and if you’re behind on your mortgage, they won’t let you stay in your home, even if you have a willing buyer waiting with the cash to buy the house and let you do just that. There’s only one exception to this rule, and it’s a fascinating one. If a bank bought its mortgages below par rather than lending the money out itself, then it’s quite likely to be open to the idea of principal reductions. For instance, when Wells Fargo bought Wachovia and when JP Morgan Chase bought Washington Mutual, they bought those banks’ mortgage portfolios at a large discount to par. It turns out that those mortgages — the ones bought from Wachovia and WaMu — have been getting modified with principal reductions.

The behavioral psychology here is very easy to understand. No bank wants to admit that it wrote idiotic loans by writing down its own assets from par. Meanwhile, it’s much easier to write up an acquired asset, which is what Wells and Chase can do if they manage to put some smart principal-reduction plans in place. (Some principal reductions, indeed, have even been done for homeowners current on their mortgages.)

Economically speaking, of course, what the banks are doing here makes no sense at all. Either writing down option-ARM (adjustable-rate mortgage) loans makes sense, from a profit-and-loss perspective, or it doesn’t. If it does — and, yes, of course it does — then the banks should do so on all their toxic loans, not just the ones they bought at a discount.

The solution, then, is clear. We need to encourage banks — and servicers — to mark their mortgages to market, and to do whatever makes sense if they’re being realistic about how much those mortgages are worth. And while it’s okay to assume that homeowners will develop an emotional attachment to their homes and pay more than necessary to stay in them, it’s not okay to take advantage of that fact to extract thousands of dollars a year in extra mortgage payments from those homeowners.

More generally, principal reduction in mortgage modifications has to become the rule rather than the exception. The reason the government’s efforts to fix the mortgage market have failed so miserably is that those efforts have centered on interest payments, not the total amount owed. A sluggish housing market will act as an economic drag for as long as millions of homeowners owe vastly more than their house is worth.

If done right, these policies can be implemented in a positive-sum way, making everybody — including the banks doing the write-downs — better off. For instance, the government could impose higher capital standards on banks that insist on marking underwater defaulted mortgages at par, and give the banks an incentive to write down principal that way, while making the whole banking system safer at the same time.

Not all deleveraging can be done this efficiently or painlessly, but that’s a great reason to grab this low-hanging fruit while we can. If we don’t want the United States to continue to suffocate under the weight of far too much debt, we have to start making serious efforts to bring our debt burden down. This one’s a no-brainer. Let’s do it.



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