New Principles for Principal Reduction

By Daniel Indiviglio

110 small house edkohler flickr.jpgThe mortgage modification conundrum continues to confound policy wonks. The Treasury's difficulty achieving success with its Home Affordable Modification Program (HAMP) demonstrates this fact well. Lowering interest rates and increasing terms don't appear to be doing the trick. So the obvious alternative is to rework mortgages so to lower their principal. The FDIC is considering this approach. Unfortunately, it's not easily done in practice. I have a few ideas to make it work.

The Conflict

How much you love or hate principal reductions depends on your perspective:

Underwater Borrowers

If you're the distressed homeowner, then you absolutely adore the idea of a principal reduction. It's like you're getting the same house, but for less money. Many borrowers who are very underwater are walking away from homes because they can't comprehend modifying a mortgage with a principal amount higher than what the home is now worth. Why do that when you can just foreclose and buy a similar home for less?

There's another nice added bonus for the homeowner through a principal reduction: if the market rebounds, and your home appreciates, you get to keep any excess funds when you sell the home again.

Lenders

Banks and finance companies hate -- hate -- the idea of principal reductions. First, they have to declare a loss on the mortgage immediately for that amount. Since many banks are still in a very fragile state, the last thing they want is widespread losses on their delinquent mortgages to all hit at once. That could result in a devastating market shock. At least if they slowly foreclose on homes, those losses will be more spread out and easier to bear.

They must also worry about precisely what I explained as the bonus to a homeowner above: if the market rebounds and the price appreciates, it doesn't seem fair that the borrower gets those excess funds. After all, the bank took a loss to keep the borrower there -- shouldn't it get that extra cash?

Everyone Else

In general, all of those homeowners who aren't having trouble paying their mortgage are quite resentful of the idea that underwater borrowers would get a principal reduction, and for good reason. Their homes have generally declined in value too, but their mortgage principal remains the same. How is it fair that those borrowers get a reduction just because they can't pay what they agreed to?

Of course, in the long run, these homeowners would probably be better off if there are fewer foreclosures. A smaller housing inventory will result in home prices rising again sooner than if the market remains unstable for several years.

The Reconciliation

So how do we get all of these parties on the same page? We need a compromise. What if lenders offered conditional principal reductions? Here's how they could work.

The bank first determines the amount the borrower can afford to pay. Then, it appraises the home. Next, it backs into an interest rate. And this is the subtlety: that interest rate might not always be terribly low, given how much the home has depreciated.

I ran a few models so to give an example. If you had a $300,000 home with a 7% interest rate, then your monthly payment was nearly $2,000. But let's say you can only afford about $1,430. One option would be to decrease your interest rate to 4%. That would do the trick. But then your mortgage principal would exceed the value of the home, which is now only worth $215,000 after declining in value by about 28%.

Instead, you'd rather walk away. But what if the bank agreed to lower your principal to its new value, while leaving your interest rate at 7%? You'd end up with approximately the same monthly payment of $1,430. But the psychological barrier of having a mortgage for more than your home is worth would be gone.

From the bank's perspective, it's getting exactly the same payment, so if the loan is paid to term, then it would be indifferent to either modification approach. The problem, of course, is that the loan may not be paid to term.

Why does that matter? Because if the homeowner refinances, then the bank losses that future income it expected from the higher interest rate. If the homeowner sells, the same result occurs. So it needs to put some conditions in place.

No Refinance Clause

The refinance problem is easy enough -- the bank could just demand that the homeowner not refinance for the life of the loan. Alternatively, it could demand she not refinance for some given time period, say, 10 years. That would still probably ensure that the bank would end up ahead of the game versus foreclosure.

Profit Sharing With Sale

The bank can't really require that the borrower not sell the property. In order to safeguard this problem, it can further demand that if the homeowner does sell, then any amount paid exceeding the new mortgage amount, up to the original mortgage amount, go to the bank. Again, this is the most extreme version. You could create some variations on this, including the bank getting a portion of the excess or fazing out the bank's right to the excess after a certain number of years.

Amortization Of Principal Loss

In the modification scenarios from the example I created, the future value of the bank's revenue from the mortgage will remain unchanged. But if it does have to declare a principal loss, regulators should allow the loss to amortize over some time period, like five years. That would have the same effect as if foreclosures were spaced out, so the bank would be more indifferent to principal reductions and foreclosure insofar as its balance sheet implications are concerned.

The Result

A conditional principal reduction won't prevent all foreclosures -- there are still situations under which a borrower won't be able to afford a home even if the principal is reduced to market value, like if he's unemployed. There will also be some borrowers who can afford a modification that will still choose not to agree to the conditions and walk away instead.

But I think it could help to break that psychological barrier for homeowners who can't imagine paying a mortgage with a principal balance much greater than what the home is now worth. And banks won't have to worry as much about the income impairment that will result from a principal modification if it has some safeguards against the sudden, drastic loss associated. With moral hazard also lessened through the conditions put in place, even the non-distressed homeowners might not be so angry.

(Image Credit: edkohler / Flickr)

This article available online at:

http://www.theatlantic.com/business/archive/2010/02/new-principles-for-principal-reduction/36746/