An interesting post on Friday by John Wake over at Arizona Real Estate Notebook regarding principal write-down during loan modification. His post with ensuing comments and discussion can be read here. John's comments were in response to thoughts published by Anthony Sanders of the W.P. Carey School of Business at ASU.
Essentially by not writing down principal during loan modification, banks are just deferring foreclosure to some point in the future (often only 3 to 6 months in the future). Diana Golobay writes about many of the same issues related to loan modification on Housingwire.com here.
My response to John's post is on his site and can also be read below the jump.
I have been arguing in my professional circle for quite awhile that the only way to slow foreclosures is to write down principal. John correctly points out that this creates a massive free rider problem and incentive for everyone to default to get a principal write-down (particularly in Arizona). But there already is an incentive for consumers to walk away - Arizona’s anti-deficiency statutes protect many homeowners (not for their HELOCs however) and the 2007 Mortgage Debt Forgiveness Act relieves many homeowners from paying taxes on forgiven debt. Consumers are just starting to get wise to these laws and will increasingly walk away as they figure this out. Their credit will be repaired long before their house regained its value to the point of no longer being underwater (10 to 15 years).
One of the problems with the Hope Act is that the principal write-down requirement is to 96% of current fair market value. So if I am a homeowner and a bank gave me a write-down to below fair market value in a still falling market - I’d sell as quickly as possible. Why wait around to be quickly underwater again? So this isn’t a plan to keep homeowners in their house - it is a plan that helps people wipe their hands clean.
Any other full principal write-down to current market value creates the same incentive for many homeowners. So I would argue that principal write-down should be undertaken, but maybe only writing down about 50-75% of the deficiency. That reduces the monthly payment, gives the homeowner a little bit of hope that within 5 years (not 15), they will no longer be underwater on their loan (so they don’t walk away), and slows the free rider problem because people trying to get out of their home right away won’t be able to use it (b/c they are still underwater). Adding in the profit share for banks as Brian suggested would further give banks incentive to do the write-down and would punish the borrower (and further mitigate the free rider problem). This would slow foreclosures and stop whole neighborhoods from experiencing the devaluation dominoes we are seeing.
Now there are still many people who would be tempted to try to take advantage of a program like this who don’t necessarily need it. Banks would have to put guidelines in place that closely look at a homeowner’s income, savings, etc. If you can still pay, you don’t qualify. In such tough economic times, I doubt too many people will quit their jobs just to qualify. Some people will figure out the loophole to qualify, but this is still much better than continuing the massive downward slide we are seeing in home values in Arizona. Banks come out much better taking this tact as John mentions.
Now the real reason banks don’t want to do this - besides the free rider problem - is that writing down principal forces them to write down their asset values and affects their solvency. Banks are holding lots and lots of illiquid assets (particularly CMBS) that they are permitted to value much higher than their market value. If they were forced to mark these assets to market - the bank would likely fail. That is another reason banks are starting to stall on processing foreclosures - they call it a foreclosure “holiday” - they don’t want to have to write down the asset value. But that’s another topic altogether…
Finally, the biggest threat to exacerbate our Arizona foreclosure problem is massive job loss. We are in a nasty cycle right now where we are going to see increasing unemployment for at least the next 6 months. People without jobs can’t pay their mortgage.
Update: My continuation of the prior comment I posted over at Arizona Real Estate Notebook:
Another reason I failed to mention that banks are reluctant to write-down principal is the loans they “hold” often are not really theirs. They are in fact servicers for the pools of loans that have been securitized and sold to investors. Under the master agreements that govern these bundles of loans, the servicers often have very little discretion to modify loans without consent of the investors who purchased the mortgage backed securities. So the banks’ hands are often tied when dealing with homeowners and they have a fiduciary duty to try to preserve as much of the value of the mortgage as possible. What investors in these securities have to come to grips with is that often writing down principal and keeping a homeowner in the home may be a better decision to preserve asset value versus foreclosure. Therefore, in cases where the loans have been securitized, the investors need to collectively approve loan modifications that would allow principal write-downs. With these securities cut so many different ways, I expect it can be a difficult process to get all investors to agree on terms.
In fact, a few early lawsuits have been filed against servicers by investors (most recently Countrywide) for doing loan modifications without complying with the master agreements. Here is the NYTimes article on the lawsuit. It’s a difficult situation and perhaps the only thing that will resolve it is if things keep getting worse and people come to their senses. My feeling is that everyone is sitting around waiting for the federal government to step in and buy assets and bail them out.
Great Blog!!! Thanks for continuing to crank out informative post after post. You guys are awesome!!! Great discussion.
LLC
Posted by: lucas law | May 18, 2009 at 11:04 PM