Tag Archives: principal reduction

Redefault Risk After the Mortgage Crisis

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A tower filled with shredded U.S. currency in the lobby of the Federal Reserve Bank of Philadelphia.

Paul Calem et al. of the Phillie Fed posted Redefault Risk in the Aftermath of the Mortgage Crisis: Why Did Modifications Improve More Than Self-Cures? The abstract reads,

This paper examines the redefault rate of mortgages that were selected for modification during 2008–2011, compared with that of similarly situated self-cured mortgages during the same period. We find that while the performance of both modified and self-cured loans improved dramatically over this period, the decline in the redefault rate for modified loans was substantially larger, and we attribute this difference to a few key factors. First, the repayment terms provided by modifications became increasingly generous, including the more frequent offering of principal reduction, resulting in greater financial relief to borrowers. Second, the later modifications also benefited from improving economic conditions — modification became more effective as unemployment rates declined and home prices recovered. Third, we find that the difference in redefault rate improvement between modified loans and self-cured loans is not fully explained by observable risk and economic variables. We attribute this residual difference to the servicers’ learning process — so-called learning by doing. Early in the mortgage crisis, many servicers had limited experience selecting the best borrowers for modification. As modification activity increased, lenders became more adept at screening borrowers for modification eligibility and in selecting appropriate modification terms.

The big question, of course, is what does this all tell us about preparing for the next crisis? That crisis, no doubt, won’t be a repeat of the last one. But it will likely rhyme with it enough — falling home prices, increasing defaults — that we can draw some lessons. One is that we did not use principal reductions fast enough to make a big difference in how the crisis played out. There were a lot of reason for this, some legit and some not. But if it is good public policy overall, we should set up mechanisms to deploy principal reduction early in the next crisis so that we do not need to navigate all of the arguments about moral hazard while knee deep in it.

Principal-ed Forgiveness

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photo by Vic

The Federal Housing Finance Agency announced a new program to implement principal reduction for seriously delinquent, underwater homeowners who meet the following criteria:

  • Are owner-occupants.
  • Are at least 90 days delinquent as of March 1, 2016.
  • Have an unpaid principal balance of $250,000 or less.
  • Have a mark-to-market loan-to-value ratio of more than 115% after capitalization. (1)

The program’s “modification terms include capitalization of outstanding arrearages, an interest rate reduction down to the current market rate, an extension of the loan term to 40 years, and forbearance of principal and/or arrearages up to a certain amount to be converted later to forgiveness.” (1) Once the borrower completes three timely payments, the principal forbearance amount can be forgiven.

This program can help just a small proportion of homeowners who have been underwater on their mortgages. Most importantly, it is being implemented years after the foreclosure crisis swamped the nation’s housing markets. But as can be seen from the criteria above, it is targeted just to homeowners with below-average principal balances on their mortgages and who are severely underwater. There are all sorts of political reasons that principal reduction was not a key component of the post-crisis housing finance reform agenda. But it is worth asking now — should we deploy it more quickly in the next crisis? What would be the principled reasons for doing that?

Many argued that principal forgiveness would reward homeowners for making bad, even immoral, decisions. With the benefit of hindsight, it would have been better to put that questions aside and ask what the best policy option for the country would have been. If outstanding principal balances could have been aligned more closely to the new normal of the post-financial crisis economy, the recovery could have proceeded more quickly.

Now would be the time for the FHFA to implement regulations to deal with the next great recession. If principal forgiveness makes sense under certain conditions, let’s identify them now and then have an easier time of it down the road.

Principal-ed Reduction

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Torn Dollar

 

The Urban Institute’s Housing Finance Policy Center has issued a report, Principal Reduction and the GSEs: The Moment for a Big Impact Has Passed. It opens,

The Federal Housing Finance Agency (FHFA) prohibits Fannie Mae and Freddie Mac (the government-sponsored enterprises, or GSEs) from unilaterally reducing the principal balance of loans that they guarantee, known as principal reduction. When director Ed DeMarco established the prohibition, he was concerned that reducing principal would cost the GSEs too much, not only in setting up the systems required to implement it, but also— and to him more important — in encouraging borrowers to default in order to receive the benefit. DeMarco’s position generated significant controversy, as advocates viewed principal reduction as a critical tool for reducing borrower distress and pointed out that the program the Obama administration had put forward to provide the relief had largely eliminated the cost to the GSEs, including the moral hazard. We believe that at the time the advocates had the better side of the argument.

The FHFA is now revisiting that prohibition, though in a very different economic environment than the one faced by Director DeMarco. Home prices are up 35.4 percent since the trough in 2011, adding $5 trillion in home equity and reducing the number of underwater homeowners from a peak of 25 percent to 10 percent. This means that far fewer borrowers would likely benefit under a GSE principal reduction program today. (1, footnote omitted)

Principal reduction was highly disfavored at the start of the financial crisis as it was perceived as a sort of giveaway to irresponsible borrowers. Some academics have disputed this characterization, but it probably remains a political reality.

In any event, I think this report has the analysis of the current situation right — the time for principal reduction has passed. But it is worth considering the conditions under which it might be appropriate in the future (for that next crisis, or the one after that). The authors make four  assumptions for a politically feasible principal reduction program:

  1. borrowers must be delinquent at the time the program is announced, in order to avoid the moral hazard of encouraging borrowers to default;
  2. borrowers must be underwater;
  3. the house must be owner-occupied; and
  4. the principal reduction is in the economic interest of Fannie and Freddie.

It is worth noting that during the Great Depression, the federal government figured out ways to reduce the burden of rapidly dropping house prices on lenders and borrowers alike without resorting to principal reduction much. Borrowers benefited from longer repayment terms and lower interest rates. Below-market interest rates are similar to principal reduction because they also reduce monthly costs for borrowers. They are also politically more feasible. It would be great to have a Plan B stored away at the FHFA, the FHA and the VA that outlines a systematic response to a nation-wide drop in housing prices. It could involve principal reduction but it does not need to.

Post-Bubble Foreclosure-Prevention and -Mitigation Options in Your Town?

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Bob Hockett has posted Post-Bubble Foreclosure-Prevention and -Mitigation Options in Seattle. I recommend it to those interested in issues beyond Seattle’s borders because it actually covers foreclosure-prevention and mitigation options across the country, although it looks at them with a Seattle focus.

He argues that

There is a potentially bewildering array of means available to at least some underwater homeowners, and these programs are also noteworthy for failing to solve the fundamental problems affecting these mortgages. There are three vitiating weakness share by nearly all of these means . . ..

The first weakness among currently available options is that they do not concentrate upon mortgage principal-reduction, meaning that they do nothing about the underwater status of underwater mortgage loans – which is the principal predictor of default and foreclosure – at all. Instead they rely upon temporary forbearance, term-extension, or interest rate reduction. . . .

The second weakness of the currently available options is that they are voluntary from the creditor’s point of view. That is problematic not because creditors lack in appreciation of their own enlightened self-interest or in desire to do the right thing, but because where there are structural or contractual barriers to principal reduction, as we shall see there are here in abundance, even creditor-benefiting such changes cannot occur on an adequate scale. Creditors are very often unable to do what benefits themselves and homeowners alike, meaning that voluntary programs can be useless.

Finally, the third weakness that the options discussed here suffer is that they do not extend to underwater PLS loans, which, as seen above, constitute the great bulk of troubled mortgage loans; they are in general available only to GSE and bank portfolio loans . . .. (11)

I found the review of “publicly encouraged debt relief” programs useful. (14) They include

  1. HAMP (the federal Home Affordable Modification Program)
  2. HARP (the federal Home Affordable Refinance Program)
  3. Miscellaneous Specialized HAMP Analogues
  4. FHA Short Refinance Program
  5. HAFA(federal Home Affordable Foreclosure Alternative)
  6. “Hardest Hit” Fund & Program (Treasury)
  7. HOPE NOW Alliance
  8. The Attorney Generals’ Settlement

Hockett also proposes some innovative approaches that he suggests that Seattle should consider including the use of eminent domain as well as a land bank. Worth the read.

 

The Weak Can Never Forgive?

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S&P has issued a report, Principal Forgiveness, Still The Best Way To Limit U.S. Mortgage Redefaults, Is Becoming More Prevalent, that asserts that its research “demonstrates the likelihood that servicers will recover a greater portion of their receivables through principal forgiveness versus other modification tools,” such as rate modification. (5) In particular, the authors found that as of March of 2013, “loans that received a principal reduction maintained the highest percentage (about 76%) of current-pay borrowers. By contrast, on average less than 50% of loans outstanding that received a modification other than principal forgiveness remained current.” (4)

I am not sure that their research actually demonstrates a causal connection between principal modification and recoveries as opposed to just providing a correlation between the two.  This perhaps naive analysis does, in any event, raise interesting and important questions about the efficacy of modifications.

And modifications are increasing.  Indeed, as of “February of this year, more than 1.5 million homeowners have received a permanent modification through the U.S. federal government’s Home Affordable Modification Program (HAMP).” (1) Since last year, there has been “22% rate of growth in the number of modifications on an additional $2.4 billion in mortgage debt.” (1) Among the big five servicers, “principal forgiveness, as a percentage of average modifications performed on a monthly basis, has increased by about 200% since the latter half of 2011.” (1) And since 2009, “servicers have forgiven principal on approximately $45 billion of outstanding non-agency mortgages.” (1)

At the beginning of the crisis, many were terrified about the impact that principal modification would have on investors. FHFA Acting Director DeMarco was also concerned about the impact of Fannie and Freddie principal reductions on taxpayers. With a new Director for FHFA on the horizon, there might be a change of direction on this.

Gandhi said that forgiveness is an attribute of the strong.  Perhaps, our housing market is now strong enough to contemplate some serious loan forgiveness.