Should Mortgage Servicer Lawsuit Settlements Include Principal Cuts?

Will the foreclosure crisis that began last fall finally provide the Obama administration the leverage it needs to bring mortgage principal reductions to struggling borrowers? Ever since homeowners began running into trouble paying their mortgages when the housing bubble popped, principal reductions have been seen as the best answer. Yet the administration has thus far been unable to make a strong program stick, as banks haven't been cooperative. Should the Treasury push for a settlement that requires principal write-downs so more struggling homeowners can avoid foreclosure?

Principal Reductions at Last?

First, why are principal reductions said to be fundamentally different from other methods of mortgage modification? As a mortgage goes underwater, with its balance higher than what a home value has dropped to, borrowers have little incentive to keep paying, even if they can. For that reason, lowering the interest rate or lengthening a loan's term will only get you so far: it makes little sense for a borrower to bother paying when they could go rent for the same price without remaining in deep debt on a home worth less than its mortgage balance.

For this reason, principal reductions have been seen as providing the motivation that borrowers need to keep paying their mortgages. If their loan balance is reduced to a level nearer to or even below their home's value, then it doesn't seem like such a bad deal.

For about a year now, the Treasury had been promising more principal reductions as a part of its otherwise weak mortgage modification program. We have yet to see any results on their principal reduction effort, though the Treasury indicates that it is tentatively planning on including results for the effort in its March report.

But the recent foreclosure crisis has provided the administration with a rare opportunity. It appears to have caught the banks and servicers clearly in the wrong, having cut corners with foreclosures. It could use that leverage to finally force banks and servicers to provide principal reductions as part of a settlement in the pending litigation. The Wall Street Journal reports that the Obama administration wants a $20 billion settlement to pay for these principal reductions.

Should the Plan Go Ahead?

For starters, it's a little unclear whether or not this plan is even plausible. Banks and servicers would have to agree to the settlement. Investors would likely have to as well, since they're the ones who own the mortgages. Finally, various regulators and state prosecutors would have to be on board. Those are a lot of variables to line up. But assuming the administration manages to do so, should it proceed?

The Big Pro: It Could Stabilize the Market

The administration may argue that this program could finally stabilize the housing market. In just the few months since the foreclosure crisis began last fall, tens of thousands of foreclosures have been delayed. That caused foreclosure rates to plummet in the latter part of 2010. The running assumption has been that these foreclosures are just delayed -- not avoided.

But what if these and more in the future could be prevented by these principal reductions? Then, recent declines in housing inventory would be real and possibly sustainable. This could be the medicine that the housing market needs to heal.

The Many Cons: Size, Timing, Fairness, Investors, Servicer Acquiesce, and Dominos

Of course, this huge imagined benefit is reliant on some very big assumptions. The most significant is that $20 billion is more than a drop in the bucket. National home prices have dropped around 31% from their 2006 peak, according to the S&P/Case-Shiller Index. Using the December median home sale price of $168,800, and an initial 110% loan-to-value ratio (which is probably conservative for many of these mortgages if you consider second liens), it would cost around $100,000 to get the average home above water. These relatively conservative assumptions would provide for about 200,000 modifications. That's minuscule relative to the millions of foreclosures we can still expect over the next few years.

Moreover, borrowers might not even be as interested in principal reductions now as they would have been, say, a year ago. At that time, home prices were rising. Today, they're falling again. So homeowners may worry that even if a principal reduction gets them above water, they'll be back below water in coming months as home values continue to decline.

Then, there's the fairness issue. This problem takes on a few dimensions. First, should just the handful of struggling borrowers who have managed to hold on for this long qualify for principal reductions? And why shouldn't borrowers continue to qualify after the program runs out of money? There have been millions of Americans that could have benefitted from principal reductions that have already lost their homes, and there will likely be millions more after this program runs out of money. And what about the millions of homeowners who are underwater on their mortgage but aren't delinquent. Is the administration really willing to reward those who happen to have good timing?

Next, there's the investor problem -- why would they go for it? Although it appears many would favor principal reduction, in theory, we're talking about a lawsuit settlement where they're the chief beneficiaries. If the banks do settle, then investors are the ones who would potentially benefit. Instead, they could force the banks to buy back some of these bad loans or provide them comparable cash damages. Wouldn't they rather just have their money now instead of giving it to defaulted borrowers who they can only hope won't re-default?

Another problem stems from this description of how the program would work, according to the Wall Street Journal article:

The deal wouldn't create any new government programs to reduce principal. Instead, it would allow banks to devise their own modifications or use existing government programs, people familiar with the matter said. Banks would also have to reduce second-lien mortgages when first mortgages are modified.

This is somewhat laughable, because we all already know the track record of banks and servicers who are left to devise their own programs to perform principal modifications: they fail to do so. Without a structured program in place, it's hard to imagine why banks would change their favored strategy of avoiding principal reductions whenever possible. They can just claim few borrowers qualified for the program.

Finally, there's the domino effect. The big, scary scenario with principal reductions is that, once they begin, everyone will want one. Earlier this month, one estimate put the percentage of underwater mortgage borrowers at 27%. Only a fraction of those homeowners is delinquent, but certainly none of them is pleased about being underwater. Once they learn of a program that could bail out their mortgage, they could intentionally go delinquent to qualify. Indeed, this is a rational response. And why would someone who is delinquent due to hardship be more deserving of a principal write-down than another person who is delinquent by choice?

This is quite a mix of problems with which a government settlement requiring principal reductions must contend. Essentially, there's reason to believe that the program won't work particularly well to stabilize the housing market or save many Americans from foreclosure. Principal reductions may have been a good idea gone stale or may need more than $20 billion in funding to have a big impact.