Some Clarification On Mortgage Principal Reductions

On Saturday, I wrote a post containing some ideas to make principal reductions more palatable to banks. I want to clear a few things up.

On Saturday, I wrote a post containing some ideas to make principal reductions more palatable to banks. Right now, banks want nothing to do with them, mostly because they don't want to declare big, immediate losses. I've subsequently gotten several comments and e-mails about what I proposed. I want to clear a few things up.

First, if you haven't read my post from Saturday, then I urge you to do so before continuing here. Much of what I say below assumes you know what I suggested.

To begin, I did not mean to propose that the government should necessarily force banks to undergo principal reductions, or that taxpayers should pay for the banks' losses in doing so. On the contrary: my suggestions were meant to explore ways in which lenders could make principal reductions work on their own terms, not by being strong-armed by the government or relying on taxpayer support. In fact, the only part of my post involving the government's involvement was if regulators were to allow banks to space the losses from principal reductions over several years. But that would just serve to eliminate the severity of an immediate loss as a motivation for banks to foreclose.

So let's put the government's influence aside for a moment and think about voluntary principal reductions from the bank's point of view. With regard to defaulted underwater borrowers, it has two options: foreclose or modify the mortgage. Experience has shown that borrowers are less likely to be interested in a modification if it leaves them well underwater. So in this market, a principal reduction would almost certainly help the chances that a modification would work. Let's consider the scenarios in the example I used on Saturday. Here are the assumptions:

Original Mortgage: $300,000 (for simplicity, the borrower still owes that amount; it was interest-only until default)
Original Interest Rate: 7%
Current Payment: $2,000
Borrower Can Afford: $1,430
Current Appraisal Value Of Home: $215,000 (28% decline)

Scenario 1: Foreclosure

Here, it's pretty likely that the bank will lose somewhere in the ballpark of that entire 28%. If the bank gets the appraisal value of the home at auction, then that would be quite lucky. It may try to get the borrower to pay back some of that difference if it was a recourse loan, but even in those situations I'm hearing that borrowers are being settled with for pennies on the dollar, i.e. the recovery amount is tiny. And that also doesn't take other administrative costs for foreclosure into account. So let's say the loss here is approximately $85,000. I think that's optimistic.

Scenario 2: Principal Reduction

Now, let's say the bank reduces the borrower's principal to $215,000, but bases the interest rate on what he is able to pay -- $1,430 per month, which leaves it at 7% for a 30-year mortgage (may need a few years extension to get the new term to 30 years, fine). That's likely higher than whatever interest rate it would get in the market right now, given prevailing mortgage interest rates. If those rates were around 5%, then that would be the same as a $266,500 loan. In other words, the bank would ultimately lose $51,500 more by foreclosing instead of a principal reduction. This, of course, assumes that the borrower isn't allowed to refinance, as I explained in my earlier post. Even if the borrower sells shortly thereafter for around the appraised value, the bank would still be in approximately the same position as it would have been through auction, but probably a little better off.

As you can see, the government played no part in the principal reduction scenario. Here, it would be in the bank's best interest to reduce principal. As mentioned, however, the bank may have to declare a loss on the principal, and that's where the government may come in -- by allowing banks to space losses over several years, they don't have the same incentive to foreclose their defaulted portfolio over that same time period so to space out losses. The government would not use any taxpayer money either.

Now don't get me wrong: this won't work in all cases. There are some borrowers who will not even be able to pay if their principal is reduced to the new market value for their home. Foreclosure is their only option. But I am also sure that there are some cases where this could work. And the housing market will stabilize a lot more quickly if the foreclosure inventory shrinks. That outcome would benefit everyone -- not just banks and underwater borrowers.