I just wrote about some problems I see with the Treasury's new effort to prevent foreclosures for unemployed Americans. But because I'm a fair journalist, I think it's also important that I write about the good in the Treasury's announcement from last Friday: its principal reduction plan. It makes a lot of sense. Here are four smart aspects of the plan, with one caveat.
115% LTV, not 100%
The idea is to reduce principal down to 115% of the loan-to-value ratio. In other words, if a home is worth $100,000 currently, then the mortgage value can be reduced as low as $115,000. Why not all the way down to what the house is worth? Because the borrower just needs enough incentive to feel that the mortgage is a good enough deal to stick with. Even though it will remain underwater, an LTV of 115% is far more reasonable than one of something like 150%.
This is also good from the lenders' point-of-view. If they foreclose on the home, chances are they'll be lucky to get the market value. So if the borrower does end up paying, writing it down to 115% of the home's value is a pretty good deal for the lenders. A little bit of premium also protects the lenders if the housing market's recovery is steeper than most people anticipate.
Graduated Principal Reduction
Another nice feature is that the principal reduction will be gradual. It will occur in steps over three years. This will have two nice side-effects. First, it will encourage good behavior on the part of the borrower to continue paying.
Second, banks presumably won't have to declare the principal loss all at once. I've mentioned that one of the big problems with principal write-downs is that lenders would have to take a big loss immediately. So I suggested it might be a smart idea to allow them to take the loss gradually. This provision appears to do exactly that. Lenders will more easily be able to stomach the loss, since it won't come all at once.
Also clever: the program is retroactive to any homeowner who has already gotten a modification under the HAMP program. Re-default is a particularly likely outcome for these previous modifications if it left the homeowner well underwater. This feature could prevent some of those re-defaults.
Strong Incentive to Lenders
Finally, the Treasury is making it pretty worthwhile for the lenders to go along. They're paying them as follows for the forgiven principal:
I'm a little unclear when a lender would collect 21 cents as indicated, since the mortgages are only supposed to be reduced up to 115%. But 15 cents on a dollar is pretty nice: remember, in foreclosure these lenders would be lucky to get the market value, which means a full loss on that principal. And that doesn't even get into the other costs involved in foreclosure.
As for the second liens, six cents on a dollar might not seem like much. But for most of these second mortgages, the alternative is zero if the house goes into foreclosure. So that makes six cents look pretty darn good. Though, it would probably be even more attractive if the associated loss on second liens could be gradual too.
*(See update below)
One Worry: No Stick?
I do, however, have one pretty significant worry. The fact sheet (.pdf) says the following about when a bank should do a principal reduction:
If NPV is higher under alternative approach, servicer will have option to use it.
This assumes that the servicer wants to use it. It appears to give the servicer the discretion of whether to use the old HAMP method or rely on principal reduction. That's a little surprising, because if lenders aren't on board, it could pose a problem. However, the benefits are pretty significant, so I would think that many lenders will gladly participate.
As a commenter points out, apparently this schedule is for 2nd liens, which I misinterpreted since the Fact Sheet says "The following schedule will be available to lenders in exchange for all principal write-downs under HAMP at the time of a loan modification." But in an earlier bullet point refers to 2nd liens, so I suspect he is right. This results in two changes:
First, there's far less incentive for lenders to write down principal. As far as I can see, there's no longer any carrot from the government for the lender to reduce principal at all. It will be a total loss. So I doubt we'll see too many principal write-downs after all.
I asked Treasury, and they indicated that the schedule does, in fact, apply to 1st mortgages, as I originally thought. Vindicated! It also, however, applies to 2nd liens. So part of the following still applies:
Second, It does still provide a much greater incentive for 2nd lien holders, however. And 2nd liens are a pretty big problem. , so the point isn't completely lost. Perhaps the Treasury believes that 1st mortgage holders don't need an incentive to modify mortgages, while the 2nd lien holders need a huge incentive? I just worry the Treasury may be overpaying for worthless 2nd liens, however.