Last March, Bank of America initiated a plan to lower the principal balance on home mortgages by as much as 30 percent for thousands of its distressed borrowers.
The announcement was a bit of a stunner because loan modification programs that are truly intended to shrink monthly payments are all about reducing interest rates or extending terms, i.e., from 30 years to 40 years. Indeed, most lenders would probably rather accept any alternative other than reducing principal as a way of helping borrowers who are underwater with their mortgages.
(Editor’s note: Bank of America announced the addition of earned principal reductions to its existing National Homeownership Retention Program (NHRP) as part of a settlement with the Massachusetts Attorney General, which had filed a complaint against Countrywide Financial Corp.; Bank of America acquired Countrywide in 2008.)
While a groundbreaker, the BofA program is limited to the old Countrywide borrowers who now find their loan balance is 120 percent of estimated home value.
For commentary on the BofA announcement, I turned to an old source, Alan White, assistant professor of law at Valparaiso University, who has been advocating for at least three years now that principal reduction is the best means of loan modification.
Although White deems the BofA announcement as a step in the right direction, he really doesn’t trust the bank to do very much with this program. Indeed, only a small percentage of the million or more distressed BofA borrowers would qualify for the principal reduction program.
The national view: More than 15 million homeowners owe more on their mortgage than their homes are worth, reports Moody’s Analytics.
"I’m a little skeptical because up until now, BofA, in general, has had an institutional culture that has been opposed to doing loan modifications," he says. "If you look at the HAMP (Home Affordable Modification Program) reports that show modification activity by servicer, BofA has typically been at the bottom rung of services."
When I interviewed White, the then-current Treasury report estimated BofA had more than 1 million 60-day-delinquent mortgages eligible for HAMP, but had modified only 20,000.
Trying to sound optimistic (although he wasn’t really), White says the announcement of principal reduction may represent a "real cultural change in BofA’s foreclosure process. I certainly hope it does."
According to the latest Treasury Department statistics, at the end of April BofA had the largest number of active trial modifications of any HAMP loan servicer (214,562) and permanent loan modifications (56,398). But BofA also had the largest number of HAMP eligible loans, and other loan servicers including JP Morgan Chase, Wells Fargo and CitMortgage had begun trial or permanent modification on a larger share of their eligible loans.
At a June 2 press conference, BofA said more than 100,000 modifications have been completed under the NHRP, and that 43,000 more NHRP-eligible homeowners had entered a HAMP trial payment plan.
NHRP-eligible loans include subprime, pay-option ARM and prime two-year hybrid ARM loans originated by Countrywide on or before Jan. 1, 2009, when the amount of principal owed exceeds the current property value by at least 20 percent and the loan is 60 days or more past due.
BofA also said it planned to align the NHRP program with proposed changes to the HAMP program announced by the Treasury Department in March to encourage principal reductions. The changes would require loan servicers to consider alternative modification approaches for underwater borrowers, allowing some to earn principal reductions over a three-year period if they remain current on their payments.
Bank of America said it may offer earned principal forgiveness over a five-year period, as it announced when launching the NHRP program, or over the three-year timeframe that Treasury outlined, depending on individual borrower situations.
White has been very critical of previous loan modification practices because these solutions really don’t do anything for the distressed homeowner, as most modifications involve capitalizing unpaid interest and fees into larger debt and re-amortizing the loans.
The good thing about principal reduction is that it realigns the principal balance with home values, he says. "Every study has found that redefault rates are lower when you reduce people’s equity situation."
Principal reduction also looks good when taking into consideration the macroeconomic outlook.
The mortgage crisis was partly caused by an increase in debt, which rose faster than household income. At the peak of the bubble, American homeowners held more than $10 trillion in mortgage debt. It had tripled in three years, but people’s income didn’t triple over the same period of time.
"There is a bunch of debt hanging over American households," says White. "We can’t just foreclose on everyone and get them to start over with a cheaper house. That’s a wasteful way to get rid of debt. There have to be some foreclosures, people have to move, but to the extent you have people who can’t afford to pay current value of the home, it’s crazy to kick them out and find someone else who can afford the actual value of the home."
Obviously, not everyone is crazy for principal reduction — otherwise there would be more of it.
At the end of last year, I interviewed Diane Penley, a managing director at Fitch Ratings in New York, on this same subject. She wasn’t a fan.
This is what she told me: "Who decides which borrowers get a reduction in loan principal? The borrowers who cannot afford mortgages, which they received with little or no downpayment? And what about the borrowers who can and are making payments today; they could actually be just as much underwater as the borrower not making payments — and will they stop making payments in hope of receiving a principal reduction?
"Take even a step further — ‘underwater’ typically means that the borrower owes more on a mortgage than the property is worth today. This would leave out all the borrowers who purchased homes with sizeable downpayments — they have also suffered a significant loss of equity – even though they may not be technically underwater."
This argument is often lumped under the category of "moral hazard."
So I asked White about the moral hazard question. He responded by saying, "Principal reduction is a pragmatic reaction to a macroeconomic crisis and it does mean to some extent that you are going to do things that are perceived as unfair. And they may be unfair. But, the same neighbor who resents having the person next door getting that reduction, if that neighbor gets foreclosed upon, that property will fall in value even more. It is not in anyone’s interest not to do reasonable principal reductions."
When BofA made its move in regard to reducing mortgage principal, Barbara Desoer, president of Bank of America Home Loans, noted, "Many homeowners who owe considerably more on their mortgages than their homes are worth are reluctant to accept a solution that addresses only the amount of the payment without an accompanying reduction in the balance due on the loan.
"We believe that by first addressing the significant underwater condition of some NHRP-eligible loans, the rates of customer acceptance of HAMP trial modifications and conversions to permanent modifications on those loans will be improved, and the homeowners will be more motivated to make payments, yielding more sustainable modifications."
Earlier this year, a LendingTree columnist reported that of the four largest loan servicers in the HAMP program, Wells Fargo Bank and CitiMortgage had also done some principal reductions, but in a limited way. JP Morgan Chase has sidestepped that particular solution to the mortgage problem altogether.
The problem is, if lenders did more principal reductions, loan losses would surface quicker and that is not a situation the banks want to experience, especially when they are claiming a recovery of sorts. And, when the home markets do recover, if the lender has done a principal reduction, it has effectively removed itself from sharing in the home’s recovery in value.
When it comes to reducing mortgage principal, what’s good for the borrower is not necessarily good for the lender, and vice versa.
Steve Bergsman is a freelance writer in Arizona and author of several books, including "After the Fall: Opportunities and Strategies for Real Estate Investing in the Coming Decade."
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