Comments on: Principal reductions: DeMarco vs Geithner A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 By: DrPaulBrewer Thu, 02 Aug 2012 17:54:48 +0000 There are alternative rules for HAMP loan modifications with and without principal reduction. Under principal reduction there are additional alternatives where the lender can reverse the order of certain steps. And any of these sets of rules will find a way to lower the payment to 31% of income.

For a while I’ve had an Unofficial HAMP loan modification calculator up at that can calculate these various rules. It is totally free, and the source code is available under the GNU public license.

While a tool like this can not answer the fundamental questions, it can be used to gain some experience with how the various rules might operate.

By: Strych09 Wed, 01 Aug 2012 20:02:16 +0000 TFF, great comment, I would just add that “shadow inventory” adds a wrinkle to your game theoretic analysis of point (1).

I’m in California, which is a non recourse state, and it’s not at all uncommon for banks to fail to foreclose on a property so they can avoid marking that mortgage loan to market (i.e., write it down). I have many acquaintances who decided to strategically default and the lender still hasn’t foreclosed or even scheduled the trustee sale 28 or 29 months after the filing of the notice of default.

And of course, even after foreclosure, any number of banks simply hold those properties off the market in order to avoid lowering the overall price level by “flooding the market” with REOs. That’s why cities like San Bernardino are considering using eminent domain to seize underwater mortgages and restructure them for lenders, because the lenders aren’t doing it themselves. That’s why some cities are passing laws obligating banks to maintain properties and do things like lawn maintenance and mosquito abatement, because properties aren’t turning over. And of course, Bank of America is actually bulldozing perfectly livable homes in some areas in order to avoid having to pay for these responsibilities and to reduce inventory in order to prop up prices.

The effect of this and Felix’s proposed widespread principal reduction scheme is to hurt the people who were responsible, waited on the sidelines during the bubble for prices to return to the reasonable/trend level, and now still can’t buy at an affordable price because normal market action can’t take place due to artificial price supports.

By: TFF Wed, 01 Aug 2012 18:35:41 +0000 Sorry, MrRFox, was poorly worded on #3. You put it more clearly. What I meant is that the bank keeps a mortgage, rather than getting the cash outright as in #2.

And yes, I wasn’t even getting into the First/Second dilemma. Coupon payments flow to both First/Second proportionately. Principal payments flow to the First before the Second. That is an irreparable asymmetry, with the “fair solution” depending strongly on the time-to-default.

A second mortgage on a heavily underwater home is effectively the interest portion of a STRIP. Values very differently if you expect a default in two years vs. five years.

By: MrRFox Wed, 01 Aug 2012 18:20:44 +0000 @TFF – your #3 option, principal reduction, the bank gets a performing loan with a face amount of current FMV. The bank gets no future appreciation in FMV, AIUI. It’s a straight-out gift of the underwater portion –

and not just to the borrower. The equally big gift-getter is the bank holding a Second Mortgage on the property, if any. A virtually worthless Second can be made instantly valuable by this partial forgiveness on the First. Big banks hold a lot of Seconds – they weren’t securitized like Firsts were.

By: TFF Wed, 01 Aug 2012 18:17:00 +0000 Also note that the cash flow on a current underwater loan is very high relative to FMV. Suppose the borrower bought for $500k, borrowed $400k at 6.5%, and the house is now worth $300k. The annual payments on the original mortgage come to $30k, or 10% of the present FMV. If the bank can collect on the underwater loan for five years, and subsequently unload it REO at $200k, then they are better off than they would be with an immediate $300k short sale.

Pushing defaults down the road is very profitable for banks, even when it leads to a lower residual value.

By: TFF Wed, 01 Aug 2012 17:34:28 +0000 Posted this down below, but is applicable to this topic and would appreciate critiques.

When a house is seriously underwater, there are four ways out:

(1) Homeowner defaults, leading to foreclosure. Bank recovers what it can, typically a fraction of FMV. Homeowner’s credit rating is dinged for 7(?) years, but (because the foreclosure process takes months) gets to live rent free for a while.

(2) Short sale. Bank receives FMV for the property, without the legal costs. Homeowner’s credit isn’t quite as badly dinged.

(3) Principal reduction. Bank receives a promise of FMV on the property in the future (bird in bush, not in hand). Homeowner retains the property (and any future gains) with no damage to credit score.

(4) Homeowner stays in the home, continues paying the mortgage, and eventually is above water again. For a property that has lost 50%, that might take a decade.

The worst outcome for the banks, by far, is #1. Their recovery, after costs, is a fraction of FMV. But this is frequently also the worst outcome for homeowners. Most cannot buy again without a new mortgage — and qualifying for a new mortgage in the wake of a default is surely difficult! So they rent for several years, repair their credit, and hope that prices/borrowing costs haven’t risen too much by the time they are ready to buy again.

The banks don’t see a heck of a lot of difference between #2 and #3. They get FMV in both cases, and they don’t REALLY want to keep that reduced mortgage. But they are very afraid of the “moral hazard” implied by #3. If they offer widespread principal reductions, then everybody with an underwater loan will want one. Right? There’s really no downside to the homeowner, if it is a free choice between #3 and #4. So the banks are doing everything they can to make principal reductions available ONLY to those who would otherwise end up in foreclosure. (Including telling homeowners that they can’t even apply for a reduction unless they are already in default.)

Does the game theory aspect make sense? Option #3 is best for homeowners, with (depending on your situation) #2 and #4 coming in second best. Option #4 is best for banks, with #2 and #3 coming in a distant second.

So banks threaten #1 (worst or second worst for everybody) to keep as many borrowers as they can in #4 (best for the banks). Homeowners largely cooperate, because they really don’t want to default and because (given rents these days) they aren’t THAT much worse off in #4 than in #1. At least not if they have the income to manage it.

The more people who willingly default, the more likely the banks are to accept #3 as a viable alternative. When they eventually come around, we’ll see a final wave of writedowns with willing participation from the banks.

But from what I’ve seen, calls for principal reduction typically do not adequately address the “game theory” aspects described above. Until they do so, they are doomed to failure.

By: Strych09 Wed, 01 Aug 2012 17:26:40 +0000 NickFFF, I seems to me you perhaps don’t get the “originate to distribute” model that banks use with mortgages nowadays. Original lenders don’t care a whit about responsible underwriting. The risk isn’t on their books, it’s been shifted out to investors via the securitization process.

I haven’t seen any evidence at all, anywhere, that mortgage brokers have any input at all into the degree of due diligence exercised by lenders during the underwriting process. Mortgage brokers want their commission, and they couldn’t care less what happens to the borrower after a closing.

You’re of course correct that “every contract has (at least) two sides”, but from a behavioral finance perspective, the only one public policy such as the one proposed here can (or should?) influence greatly is the borrower’s side. They have to resist the urge to take out a mortgage they can’t afford.

The fear of being underwater for ten or more years would be a great motivator, and would be effective in counterbalancing the sales pitches from shifty unscrupulous mortgage brokers who want to close deals at any cost. If we take away that fear by allowing principal reduction, and thus the future expectation that declines in real estate values will be met by government intervention, then we create or contribute to the catalyst for the next bubble.

That is only one reason of many that widespread principal reduction is a bad idea, and why I’ve never understood why Felix is so attached to it.

By: Eric377 Wed, 01 Aug 2012 16:26:24 +0000 DeMarco’s stance is beneficial to the Obama’s reelection campaign. For the reasons well explained in the above comments – particularly TFF’s – sending billions of taxpayers’ dollars to principle reductions will generate a net ill will that the President can’t really afford. Talking as if you wanted to do something like this, but not actually doing it is probably the political sweet spot. If actually done it would take about 10 milliseconds for stories and ads to appear about the absurdities and injustices of the allocation of national resources. And they’d mostly be true and they’d be easy to understand, like: you’re such a moron for not leveraging yourself to the hilt that you deserve to help payoff your neighbor’s home. Maybe he’ll invite you out on his boat someday – but probably not.

By: Curmudgeon Wed, 01 Aug 2012 15:23:07 +0000 I don’t know what the right call is here. But when I read this, see Counterparties promoting a call by Krugman to fire DeMarco, and a prominently posted article from WaPo on the 370,000 jobs that would be created (ugh!), I have to call BS. I recognize that you’re under no obligation to be unbiased in your opinions, but sometimes you just go so far around the bend that it makes me want to not believe a word you write.

By: Curmudgeon Wed, 01 Aug 2012 12:50:36 +0000 @TFF: +1