Are principal reductions coming. Loanonwers certainly hope so, but the arguments against are more compelling than the arguments in favor.
Irvine Home Address … 8 CHARDONNAY 16 Irvine, CA 92614
Resale Home Price …… $349,900
But when I seek out your voice
My ears are overcome with noise
You show and tell with greatest ease
And when the story takes a twist
It folds like a contortionist
Slight of hand and quick exchange
The old tricks have been rearranged
Engaged in crime I grasp my throat
Enraged my mind starts to smoke
Enforce a mental overload
Angry again, angry again, angry
Angry Again — Megadeth
When I first read the article Principal Cuts on Lender Menus as Foreclosures Rise, I thought my head might explode. The idea of forgiving principal, or worse yet paying off mortgages with taxpayer money, enrages me.
The linked article is long, and it makes many of the arguments in favor of forgiving principal. I want to examine these arguments and try to decipher the truth.
The start of this article smells like a Treasury Department leak,
“Efforts by U.S. banks to help
distressed homeowners have focused mainly on temporary fixes
such as interest-rate reductions that may only put off the day
of reckoning, despite policy makers wanting them to do more.
Banks may be forced to resort to a remedy they’ve been
trying to avoid — principal reductions — as another wave of
foreclosures looms and payments on risky loans rise, Bloomberg
BusinessWeek magazine reports in the Jan. 18 issue.
Who said policy makers want them to do more than they do now? Banks may be forced? How? Another wave of foreclosures will not force them to do anything. It might force policymakers to appoint a Foreclosure Czar or some other useless symbolic act, but if forces banks to do nothing.
Negative equity leads to default
The article goes on, ““The evidence is irrefutable,” Laurie Goodman, senior
managing director of Amherst Securities Group in New York,
testified before the U.S. House Financial Services Committee on
Dec. 8. “Negative equity is the most important predictor of
I covered that one in Cure Rates. Policy makers have reason to look at this relationship because increasing equity is the only way to prevent more foreclosures. Everyone in power already knows this which explains why the US Government is now acting conservator of the GSEs, sustaining the new home market through FHA, and working together with the Federal Reserve to buy the GSE debt at inflated prices. They are working to create equity through payment affordability, but they can only go so far. The hopelessly underwater will only make it through principal reductions. In short, we have to give them money.
“The 25 percent plunge in residential real estate prices
from their 2006 peak has left homeowners underwater by $745
billion, according to research firm First American CoreLogic –a
number that tops the government’s $700 billion bailout for
banks. That’s why Federal Deposit Insurance Corp. Chairman
Sheila Bair is considering incentives for lenders to cut the
principal on as much as $45 billion of mortgages acquired from
seized banks. “We’re looking now at whether we should provide
some further loss-sharing for principal writedowns,” says Bair.”
First, look at the enormity of the problem — $745
billion. How much of that was mortgage equity withdrawal? How much HELOC abuse are you willing to subsidize?
Second, if Ms. Bair is going to spend $45 billion to reduce mortgage balances, what exactly is gained? If there is a foreclosure or a principal reduction, the final result is a homeowner in a property they can afford. By reducing principal to avoid a foreclosure, we are rewarding the foolish homedebtor who previously outbid the prudent renter by using toxic financing. Now that the prudent renter is ready to deploy their downpayment with a stable loan to acquire the house — a house they should have rightfully had to begin with — the Government wants to step in and take the prudent renter’s tax money and pay off the mortgage of the foolish homedebtor squatting in the prudent renter’s home. Screw that.
Moral hazard of principal reduction
This is a moral hazard issue. Remember, responsible homeowners are NOT losing their homes the foolish and irresponsible are.
“Some lenders may be coming around to the idea of principal
reduction. “If you can right-size the mortgage and return to an
equity situation, the incentive is to stay,” says Micah Green,
an attorney at Patton Boggs in Washington and a lobbyist for a
coalition of mortgage bond investors. Banks can either forgive
principal outright or defer it. In deferrals the borrower must
pay back the full amount on the original mortgage when he sells
the property; if the ultimate sales price doesn’t cover the
principal, the homeowner has to pay the difference, making it a
less effective tool.”
First, no lender anywhere is coming around to the idea of principal reduction. Principal reduction inevitably leads to moral hazard and the collapse of banking, and lenders know this. When banks start giving money away, they are no longer banks; they are charities.
Second, notice how we have a need to “right-size” the mortgage? This is a wonderful choice of language. You almost forget to ask, why weren’t the mortgages right-sized to begin with? And shouldn’t those who “wrong-sized” these mortgages fix the problem?
Deferred balances (zero coupon bonds)
Then we get into the juicy stuff about deferred loan balances… finally… I predicted back in April 2007 in How Homedebtors Could Avoid Foreclosure:
“As much as it pains me to write this, there is a short to medium
term solution to the foreclosure problem: convert part of the mortgage
to a zero coupon bond.
For those of you not steeped in finance, a zero coupon bond is a bond
which does not make periodic interest payments. Think of it a zero
amortization loan. You don’t pay either the interest or the principal,
and both accumulate for the life of the loan. The loan would be due
upon the sale of the house.
Here is how it would work for our typical homedebtor: Assume our
financial genius utilized 100% financing and took out a $500,000
interest-only mortgage with a 2% teaser rate that is due to adjust to
6%. Let’s further assume his real income (not what he reported on his
liar loan) could support a $1,500 payment on a $250,000 conventional
30-year mortgage at 6%. The bank could convert $250,000 to a
conventional mortgage, and convert the other $250,000 to a zero coupon
bond at 6% due on sale. The homedebtor can now make their payment, and
they get to keep their house. But here is the catch: when they sell
their house, they will owe the bank a lot of money. If they sell the
house in 20 years, they will owe $800,000 on the zero coupon bond note.
In other words, all the equity gain on the value of the home will go to the bank.”
Do you understand how this mechanism works? The effect of loan deferment is identical to Option ARMs; you add to the mortgage balance, and you pay compound interest on this new balance. If you want to fully understand why this is such a bad idea, go back and read How Homedebtors Could Avoid Foreclosure.
Losing is winning
“Banks that negotiate principal reductions have seen positive
results. Principal forgiveness can be more than twice as
effective in slowing re-defaults than reducing an interest rate,
according to a December study by the Federal Reserve Bank of New
York. Cutting a homeowner’s principal would be especially
powerful in Florida, Nevada and Arizona, markets likely years
away from recovery, said Joseph Tracy, executive vice president
of the New York Fed and coauthor of the study.”
When the author wrote that first sentence, I wonder if he giggled? Banks lose money, but it is positive. I am amazed that a VP at a FED bank would write something so laughably stupid.
“Lenders are going to eat the losses at some point in
time,” Tracy said. “There’s a real chance to recognize the
loss by forgiving principal today instead of waiting.”
Is this a sales pitch to get lenders to act; lose now or lose later? How does a bank benefit from taking this loss today, particularly when most believe they can hold on and take a smaller loss later? Do you see why we are building a shadow inventory?
Wells Fargo is forgiving loan principal!
Every Wells Fargo customer should feign poverty and get a principal reduction. Is your spouse out of work? Perhaps your spouse should quit work while you negotiate a principal reduction?
Last year, Wells Fargo & Co. cut $2 billion of principal on
delinquent loans. After the modifications, the six-month re-
default rate on those loans was roughly 15 percent to 20
percent. That’s less than half the industry average. “We are
very comfortable with what we’ve been doing,” says Franklin
Codel, chief financial officer of the bank’s home-lending unit.
“We offer a principal reduction if that makes sense for that
individual borrower’s situation.”
Wells Fargo has publicly announced they are forgiving principal on home loans. What are you waiting for?
Back to the article, “When principal reductions were granted for pay-option
adjustable-rate mortgages — loans with high default rates
because they enabled borrowers to pay less than the cost of
interest as the principal increased — the re-default rate after
60 days fell to 6 percent, according to Mortgage Metrics.”
Loan Modifications don’t work
OMG! Six percent of modified loans cannot even make two payments, and this is touted as a success? And how much principal reduction are we talking about? Remember last weeks post Option ARMs Leave Borrowers No Good Options where I showed a sample property where the payment was about to increase from $1,939 to $3,708? Is the owner of that property entitled to keep it making a $1,939 payment? If that is all they can afford, a principal reduction program should set out to reduce the payment to that level.
The more ridiculous the teaser rate and the more risk a borrower took on, the more they will be rewarded by a principal reduction. People who used Option ARMs crowded out the prudent, and now the prudent get to subsidise them. Is everyone excited about that?
The conflicting interests of mortgage lenders and home-
equity lenders is a roadblock to doing principal reductions.
Banks, credit unions and thrifts held $951.6 billion in home-
equity loans as of Sept. 30, according to Federal Reserve data.
Mortgage lenders don’t want to cut principal unless the
home-equity lenders agree to take a hit. Typically, though, the
home-equity lenders are reluctant; much of the value of their
loans would be wiped out. That could drive more banks into
insolvency, says Joshua Rosner, an analyst at investment
research firm Graham Fisher in New York.
Maybe there is a silver lining in this after all. If principal reductions serve to wipe out HELOC lenders, then I say, bring them on.
Renter’s Tax Credit
Anyone who rented during the 00s and failed to participate in the Ownership Society is now being asked to bail out the disaster created by everyone else. Renters are blameless, and if they saved during the 00s, they are being asked to pay the most and are obtaining the least for their efforts. Owners got a free ride on the HELOC gravy train, pampering themselves with fancy meals and the ultimate in entitled extravagance — clothing poodles.
I have a solution. I want the Federal Government to pass a Renter’s Tax Credit that grants everyone who did not claim a home mortgage interest deduction a tax credit — a direct government gift. The tax credit amount should be equal to the average loan balance forgiven. For instance, if homeowners get an average principal reduction of $12,000 (some will need hundreds of thousands), then renters should get a $12,000 tax credit. After all, if the most foolish overextended and imprudent homeowners, are going to get a payment, give me my equal payment — bribe me — then I will be OK with it.
Isn’t that what this is about? The government takes our money and gives it to the constituency with the most clout. Do pissed-off renters have enough pull to get a $12,000 direct payment sent to them? Homeowners think they do.
Principal Reductions are a bad idea
Diana Olick has a post last week, Are Principal Writedowns the Answer to Housing Crisis? She aptly stated, “I would honestly rather see my home’s value go down than see the guy next door (figurative: my neighbors are lovely and fiscally responsible) who made a poor/negligent financial decision get a mulligan at my expense.”
I could go on, but the case against principal reductions is pretty strong. Of course, underwater borrowers — and there are many of them — think principal reduction is a great idea. They may have enough political clout to get policy makers to consider the idea, but there is no way this comes to pass. Over the next several months, Congress is going to turn its attention to regulation of our financial markets. Dumb ideas like this one will be touted by grandstanding legislators while the lending industry quietly lobbies to kill it. If you are hoping for a reduction in your loan principal, don’t hold your breath.
Irvine Home Address … 8 CHARDONNAY 16 Irvine, CA 92614
Resale Home Price … $349,900
Income Requirement ……. $74,693
Downpayment Needed … $12,247
3.5% Down FHA Financing
Home Purchase Price … $205,000
Home Purchase Date …. 4/18/1990
Net Gain (Loss) ………. $123,906
Percent Change ………. 70.7%
Annual Appreciation … 2.7%
Mortgage Interest Rate ………. 5.27%
Monthly Mortgage Payment … $1,869
Monthly Cash Outlays ………… $2,610
Monthly Cost of Ownership … $1,980
Baths 1 full 1 part baths
Size 1,348 sq ft
($260 / sq ft)
Lot Size 1,348 sq ft
Year Built 1980
Days on Market 3
Listing Updated 1/7/2010
MLS Number P716438
Property Type Condominium, Residential
According to the listing agent, this listing may be a pre-foreclosure or short sale.
Gracious and large 1 bedroom + 1 den unit demonstrates pride of ownership throughout the property! The unit surrouds a private atrium with brick fountain and waterfall! The living room is dramatized by the vaulted ceiling, recessed lightings and a fireplace. The den is currently used as a guest bedroom with folding doors and a private deck overlooking the atrium. Attached 2 car garage with automatic roll up garage door and laundry hookups. This property locates in an award winning Woodbridge community features two ‘landmark’ lakes and swimming lagoons, two beach clubs (with boat docks), 24 tennis courts, 16 pools plus many other recreational amenities for use by the residents!
surrouds? Other than that misspelling and the occasional exclamation point, this description is not bad.
Notice this property has only appreciated at 2.7% since 1990. Property values go up to match wages which have gone up 4.4% annually since the 1970s. This property was purchased at the peak of the previous bubble, and it has not fallen to its eventual bottom of this bubble. Many markets in California will show zero appreciation between the 1990 peak and the 2012 trough.
The 1990 owner was not the current one. The current owner was a grade D HELOC abuse who managed to triple his debt.