Upside-Down Properties and Mortgage Modifications

Why Mortgage Principal Reduction is not Such a Bad Idea

Thanks to the burst in the housing bubble, there are perhaps a million homeowners with mortgage balances greater than the market values of their homes. This is know colloquially as being "underwater" or "upside-down." In some areas of the US, the drop in prices was relatively small — 10% to 15% — but in others such as the Las Vegas area, parts of Florida and Arizona, and California's central valley, home prices are less than half of their peak.

Owners of upside-down properties have, of course, a huge liquidity problem. If, for whatever reason, an owner wants to sell their property they need to enter into a short sale or deed-in-lieu-of-foreclosure agreement with their mortgage servicer. These are voluntary agreements in theory, but in practice the mortgage servicer dictates the terms and conditions of these contracts. The only viable alternative for most homeowners is to default and allow foreclosure.

The problems with short sales and deeds-in-lieu-of-foreclosure are many:

• Short sale and deed-in-lieu-of-foreclosure contracts vary widely in their terms and conditions. In some instances, the homeowner has liability for the deficiency balance, and in other cases he or she does not.
• Mortgage servicers vary widely in how quickly they process short sales and deeds-in-lieu-of-foreclosure deals. In many instances, mortgage servicer delays scuttle deals.
• Contracts with investors give mortgage servicers incentives to encourage foreclosure, even though foreclosure results in higher costs to the borrower.
• Mortgage servicers are understaffed with inefficient processes. This results in delays for homeowners learning whether they qualify for a short sale or deed-in-lieu-of-foreclosure, and homeowners needing to resend application documents repeatedly.

Upside-Down Properties and Mortgage Modifications

As many as 4 million homeowners of upside-down properties cannot afford their mortgage payment, and would like to stay in their homes. For these homeowners, the promise is a mortgage modification. In 2009, the Obama administration and the Treasury Dept. launched the Home Affordable Modification Program (HAMP).

Since 2009, 607,607 permanent modifications were started, but 68,114 have been canceled which means 539,493 homeowners remain in active modifications. The "permanent modifications," which last for five years, reduce borrowers' monthly payments by roughly $500 through reductions in the interest rate, extensions of the mortgage terms and temporary forbearance of principal owed. There is no debt forgiveness in HAMP.

HAMP is voluntary, and there are no penalties for violating program guidelines. Servicers receive $1,000 payments for permanent modifications, but servicing incentives remain for delinquency and foreclosure.

Bills.com readers report the following deficiencies in mortgage servicer performance in HAMP:

• Trial modifications that last longer than the standard three months
• Banks losing paperwork, and banks foreclosing on readers in trial modifications
• Modification proposals that extend the term to 40 years
• Addition of heavy fees and penalties to existing principal.

The result is modified loans under HAMP cost the homeowner far more than originally contracted. However, qualified homeowners see a reduction in monthly payments, which allow some homeowners to stay in their homes and avoid foreclosure.

Getting a Haircut: Principal Reduction

Principal reduction is cutting the balance of the mortgage to the appraised value of the property, or a very large fraction of the appraised value. In the banking world, principal reduction is known as "getting a haircut" because, like a haircut, it reduces the perceived height of the person getting cut. There are several arguments in favor of a large-scale principal reduction:

• It will end short sales and deed in lieu of foreclosure because homeowners can sell their property at or lightly above the balance of their mortgage
• Foreclosures will be curtailed significantly because homeowners have the liquidity to sell their homes. Borrowers with positive equity simply do not default
• Home values will stabilize and start to rise because potential home buyers who are waiting for the market to bottom-out will see the bottom is reached and will enter the market
• Lenders will be more secure and apt to lend because home values are stable
• Banks bailed out by taxpayers need to suffer a little pain now for the good of their customers

Banks argue against the idea of a haircut. So did two Federal Reserve Bank of Atlanta staff members and one from the Boston Fed in an early March 2011 blog. Here are quotes from their blog:

...suppose the borrower owes $150,000 on a $100,000 house. If the lender forecloses, let's assume it collects, after paying the lawyers and the damage on the house, etc., $50,000. However, if it writes principal down to $95,000, it will collect $95,000 because the borrower now has positive equity and won't default on the mortgage. Lenders could reduce principal and increase profits! The problem with the principal reduction argument is that it hinges on a crucial assumption: that all borrowers with negative equity will default on their mortgages. To understand why this assumption is crucial to the argument, suppose there are two borrowers who owe $150,000 but one prefers not to default (...) while the other defaults. If the lender writes down both loans, it will collect $190,000 ($95,000 from each borrower). If the lender does nothing, it will eventually foreclose on one and collect $50,000, but it will recover the full $150,000 from the other borrower, thus collecting $200,000 overall. Hence, in this simple example, the lender will obtain more money by choosing to forgo principal reduction. The obvious response is that the optimal policy should be to offer principal reduction to one borrower and not the other. However, this logic presumes that the lender can perfectly identify the borrower who will pay and the borrower who won't.

The authors state lenders will never be able to pick who will and will not default due to "asymmetric information": only the borrowers have all the information about whether they really can or want to repay their mortgages, and state that it is easy to purposefully miss a couple of mortgage payments, especially if doing so results in a principal reduction.

However, where the authors' argument falls apart here is that it may be easy to miss a mortgage payment, it is difficult to fake a hardship. For example, if a homeowner states that the financial hardship is due to unemployment of a reduction in wages, which are typical in hardship cases, both of those are easy to prove. For example, a homeowner can provide a layoff notice, unemployment application, or before-and-after paystubs to show a reduction in household income.

Let us assume for a moment that mortgage servicers find a way to figure out which homeowner will likely default. The short answer is "investors." Most mortgage investors today are governments, insurance companies, state and private retirement funds, and charitable endowments. Investors are open to the idea of principal reduction, but are frustrated with the state of mortgage servicing today.

In an Association of Mortgage Investors white paper, investors placed the blame for foreclosure problems on bank servicers. The group argues that mortgage servicers are:

• Woefully understaffed
• Secretive to homeowners about their options
• Non-transparent to investors regarding even basic information about the mortgages

The Association of Mortgage Investors argues that upside-down mortgages should be refinanced to a 97.7% loan-to-value (LTV) in accordance with the FHA Short Refinance program. It also argues in favor of allowing bankruptcy courts to reset a mortgage balance (a so-called voluntary cramdown).

Resolution

Principal reduction may become a reality soon. In early March, a coalition of all 50 state attorneys general announced they are close to a $20 billion deal with large mortgage servicers that may involve mortgage modification.