The latest idea bubbling up in the world of real estate is the use of principal reductions to stem the foreclosure tide, the theory being that if we lower mortgage balances then homeowners will have smaller monthly payments and fewer foreclosures.
It sounds great, but don’t look for lenders to gleefully cut mortgage balances anytime soon. In fact, principal additions rather than principal reductions are the rule of the day.
“Most modifications,” says the State Foreclosure Prevention Working Group, “result in payment reductions but principal reductions remain rare. Despite the growing number of loans that are ‘underwater’ (where the homeowner owes more than the property is worth), only 9 percent of loan modifications in October 2009 involved reducing the unpaid balance by more than 10 percent. More troubling, more than 70 percent of modifications result in an increase in the principal amount owed.”
The Lender’s View
We usually think of home mortgages as debt, but from the lender’s perspective the very same loans look different. To a lender a $200,000 mortgage with 5 percent interest is an asset. No less important, to a lender that asset has a marketplace value, meaning it can be sold to others.
How much is the lender’s asset worth? If investors can buy mortgages that yield 6 percent, then the value of the lender’s asset can only be sold at discount because investors will not pay full price for a 5 percent yield in a 6 percent market. Alternatively, if mortgage rates fall to 4 percent then the lender will be able to get a premium by selling that 5 percent note because investors will pay more to get a 5 percent return in a 4 percent market.
So far, so good — until we get to option ARMs and other toxic loans that allow negative amortization. With negative amortization the borrower is allowed to make monthly payments during the first few years of the loan term which are so small they do not even cover interest costs. While negative amortization has been added to the debt for accounting purposes and has been taxed in the year earned, it hasn’t actually been collected and in many cases will never be collected.
Imagine that we want to help borrowers so we reduce the principal amount of a distressed mortgage, from say $200,000 to $150,000.
• With less principal, the monthly payment should be reduced. This is true with fixed-rate loans but may or may not be true with ARMs. The problem? If rates rise enough, then even with a smaller balance monthly ARM payments can increase. Most distressed loans, of course, are adjustable.
• With less principal the value of the lender’s asset goes down. It’s not a $200,000 mortgage anymore. Done on a massive scale, principal reductions will produce huge losses for lenders, insurance companies, pensions and other mortgage holders.
• If they write down balance reductions as uncollectible debts, lenders will be entitled be re-state results and get back the taxes paid when they were reporting profits.
The Real World
While formal modification programs are not producing much in the way of loan reductions, principal cuts are actually common.
“In practice we’re already seeing principal cuts,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the country’s leading foreclosure marketplace. “When a home is sold at discount in the foreclosure process the result is a clear and visible principal reduction. Short sales are examples of principal reductions.
“What’s different with the new wave of principal reductions is that they’re being used to help current borrowers remain in place,” he said. “A limited number of lenders are now agreeing to voluntary principal reductions for distressed borrowers in hard-hit local markets because losses through the foreclosure process and short sales would be even worse.”
What About The Government?
Lenders argue that any government program which requires a reduction in principal values would be a “taking” of private property, something banned by the Fifth Amendment without just compensation. Because of lender challenges, a government program that forces lenders to reduce principal balances would stumble and lurch through the court system for years, by which time the result would be irrelevant for most troubled homeowners.
With all the accounting issues and changed asset valuations, what about foreclosures? Will we see fewer of them if we reduced principal balances?
The data to this point is unclear. The government’s Making Home Affordable program is largely an effort to lower monthly payments with federal subsidies, not an effort to reduce loan balances. Principal reductions — especially for loans which have allowed negative amortization — may not be large enough to make a practical difference for distressed owners. And borrowers who have lost their jobs may be stuck with bills that cannot be paid even if monthly mortgage costs are substantially reduced.
Truth is, the only reason lenders will reduce principal balances is when it’s to their advantage. Reducing principal balances will instantly produce big and hideous losses, something lenders don’t want but something lenders will accept if the probability of even bigger and more hideous losses from short sales and foreclosures can be avoided.
Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com.
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