Underwater Home-Owers: Demand Principal Reductions

The FDIC is proposing a test program of principle reduction for negative equity homeowners.   

But why is the FDIC required? An intriguing private sector solution would be a negotiated principle reduction between borrower and lender — no government intervention is needed.

Let’s begin exploring this idea by looking at a Washington Post article from today (FDIC to test principal reduction for underwater borrowers):

“The Federal Deposit Insurance Corp. is developing a program to test whether cutting the mortgage balances of distressed borrowers who owe significantly more than their homes are worth is an effective method for saving homeowners from foreclosure.

The program would be aimed at a growing population of homeowners who are underwater on their loans, estimated at more than 20 percent of borrowers, or 11 million homeowners. Economists consider these borrowers among the most vulnerable to foreclosure, and some industry officials worry that more of them will simply walk away from their mortgages, or “strategically default,” rather than spend a decade or more trying to regain positive equity.

Under the FDIC program, borrowers would be eligible for a reduction in their mortgage balances if they kept up their payments on the mortgage over a long period. The performance of those borrowers would be compared with borrowers given more traditional mortgage relief packages, such as those that cut the interest rate on loans.”

It only requires basic math skills for all parties to recognize that it is in the banks interest to avoid foreclosures. Underwater borrower with this knowledge — and the cojones — should let the bank know they understand simple math: Foreclosures = 50% bank loss.

They can then “engage in an arm’s length, Wall Street style negotiation.” Not precisely a threat, but simply laying out clearly what the mortgagee’s options are.

Imagine if a negative equity home-ower said to their lender:

“The fact is you lose ~50% (40-60%) on a foreclosure sale of a 2004-08 vintage mortgage.Since Morgan Stanley and other who have defaulted and walked away from money losing commercial real estate transactions they could not renegotiate, I am going to do the same: Unless you cut a substantial percentage of the principal (~20-30%) owed, then I will choose to strategically default (walk-away).”

I suggest bypassing the FDIC and going straight to your lender. Where the FDIC could be of assistance would be to prod the lender to consider the alternative to foreclosure.

My guesstimate is that of the 5 million probable future foreclosures, this mod would be applicable to about 20% of them. Note that a recent report from the Office of the Comptroller of the Currency implies that banks have figured this out: In Q3 of 2009, 13% of loan mods included a principal reduction, up from 10% in Q2 ‘09.

Of course, if Congress didn’t force FASB to eliminate mark-to-market on holdings, the banks wouldn’t be able to, Japanese style, wait the whole mess out over the next decade or two.

There are additional elements involved.

The HAMP approach (which isn’t working very well):

“Lenders have been reluctant to cut the principal balance owed by distressed borrowers, arguing that it would encourage homeowners to become delinquent even if they can afford their mortgage. Instead, the industry has focused on providing mortgage relief by lowering a borrower’s interest rate or extending the terms of a mortgage to 40 years.

We know borrowers do not benefit much from these mods –  a 1% lower, 40 year mortgage still makes most of these homes too expensive. It does little for the ability of the underwater borrower to carry the property. And these HAMPS fall into default at a very high rate — 60-80%, depending upon circumstances.

Final point:

“In some cases, a portion of the principal balance is put into a second mortgage that does not have to be paid off until the borrower sells the home or refinances.”

That was my 30-20-10 proposal some time ago. That is a good fall back proposal — move 30% of my mortgage into a 10 year, interest free 2nd mortgage.

A straight up principle reduction is the way to go, with a balloon mod an alternative option.

Source: FDIC to test principal reduction for underwater borrowers Renae Merle Washington Post, February 26, 2010; A20 http://www.washingtonpost.com/wp-dyn/content/article/2010/02/25/AR2010022505817.html

Originally published at The Big Picture and reproduced here with the author’s permission.
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3 Responses to "Underwater Home-Owers: Demand Principal Reductions"

  1. Curtis Henson   February 27, 2010 at 9:39 am

    Once again the “logic” doesn’t mesh with the “nature.” Bankers are playing a vulture’s game, waiting the borrowers out. They have no incentive to help people who can barely pay their bills. And they would rather hope that those who can’t, can hang on for “economic recovery.” It’s a game of attrition that bankers are not going to play, outside of their own favor.Our legislator’s “false hope” home-mortgage assistance program has a narrow notch of assistance between two sides of a disclosure Catch 22. Borrowers fear admitting they need help so most won’t. If they ask, most often one of two things will happen: 1) They will be identified as making too much to qualify, but get their credit rating reduced for asking. 2) They don’t earn enough to keep the house, even at a modified rate, so the bank forecloses without even giving them the modification to buy time to find a buyer.There is only one fair way to dole out mortgage assistance: An immediate, blanket mark down of “ALL” mortgages to current market values, a rate reset to 5 percent and a term adjustment to 30 years. Those who don’t need the reduction will use it to stimulate the economy. Those who need it will stay in their homes. And for the remaining few there will be no foreclosure as they will be able to get out “even” or on a short sale.EVERY homeowner in America was pilfered by lenders in this real estate disaster. Any assistance should be doled out to EVERY HOMEOWNER! The banks need to sober up to an immediate realization of their true balance sheets, so the government can go forward with bank closings, and/or temporary bank nationalizations.Bottom line: Lenders ripped off the American people. They took federal assistance when they should have gone bankrupt and/or been nationalized. They owe the people.The people are unquestioningly justified in their hatred of banks, Wall Street and Washington. Unless the legislature approves a satisfactory reparation to home owners between now and November 2nd, legislators will lose their jobs. I’m from Arizona. I’m talking to you John McCain.

    • Curtis Henson   March 1, 2010 at 12:23 pm

      Multiple loans securing a property should not overly complicate a principle reduction. Simply calculate a principle reduction percentage based on the ratio of current market value to total loan balances outstanding. Then apply the reduction to each loan based on its percentage of all loans on the property. Then each loan would be set to 5 percent, 30 year fixed. They remain separate loans with their respective lenders.The only conversation between the lender and the borrower should be to confirm the specifics of all loans on the property. Beyond that the borrower should not have to disclose or do anything. It was a deceptive calculation that bundled these loans without the borrower’s knowledge or involvement, in the first place. All excuses for not dissecting these bundles are just that, excuses. The lenders must suffer. The investors must suffer. They greedily, carelessly accepted the loans and the risk, in the first place.Once these losses are realized, the housing crash will be over. Home values will rise immediately. Home sales will rise. New home construction will expand. Construction jobs will return. For families, the reduction in monthly payments will in most cases be redirected to buying necessities and durable goods. Families will be able to breathe again. The positive cash flow effects are incalculable and far outweigh the losses to the lenders.The lenders? They are lifeless corporations. They have eternity to recover. People have a finite time on this earth. Give them a chance to live life with a measure of dignity, and at least hope of prosperity. Give the people a reason to believe that our system of government is by and for the people.

  2. Guest   March 1, 2010 at 7:22 am

    The problem with principal modifications is handling the 1st/2nd lien issue. A large number of the second liens are held by the biggest banks that also service the first lien, eg. Citi, Wells, BOFA. Obviously potential conflicts of interest.Most securitized (1st lien) mortgage investors balk at the idea of giving a principal reduction on a 1st lien loan when a 2nd lien is outstanding. Wipe out the second lien loan and the negative LTV picture looks a bit different.