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More Talk of Mortgage Principal Reductions

By JLP | February 24, 2011

In today’s WSJ:

The Obama administration is trying to push through a settlement over mortgage-servicing breakdowns that could force America’s largest banks to pay for reductions in loan principal worth billions of dollars.

Terms of the administration’s proposal include a commitment from mortgage servicers to reduce the loan balances of troubled borrowers who owe more than their homes are worth, people familiar with the matter said. The cost of those writedowns won’t be borne by investors who purchased mortgage-backed securities, these people said.

Further…

So far, most loan modifications have focused on shrinking monthly payments by lowering interest rates and extending loan terms. Banks, as well as mortgage giants Fannie Mae and Freddie Mac, have been shy to embrace principal reductions, in part due to concerns that many borrowers who can afford their loans will stop paying in the hope of being rewarded with a smaller loan. But some economists warn that rising numbers of underwater borrowers will drag on housing markets and the economy for years unless more is done to help them.

I know I sound like a broken record but I know a better way. Foreclose. It would clear out the system much quicker than all these “fixes” would.

Source: U.S. Pushes Mortgage Deal

Topics: Credit Crisis, Mortgages | 42 Comments »


42 Responses to “More Talk of Mortgage Principal Reductions”

  1. Jon Says:
    February 24th, 2011 at 11:06 am

    Here’s a solution. Free market. Get rid of the incentives of the government that makes banks get reimbursed from Uncle Sam each time they foreclose on properties.

    In New Zealand the government stopped subsidizing farms which decreased the value of the property. This in turn made the banks reevaluate the properties and the banks at the cost. It was a free market function (I’m assuming the government didn’t intervene, of course, they could have).

  2. BG Says:
    February 24th, 2011 at 11:20 am

    I agree JLP: foreclose!

    Sure it would be painful for a year or two, but the future will be on a much stronger footing.

  3. JLP Says:
    February 24th, 2011 at 11:24 am

    Jon and BG,

    It really is the only answer. This is year 3 of this debacle and there’s really no end in sight.

  4. RA Says:
    February 24th, 2011 at 11:51 am

    Ha, ha. They probably would if they could. But the banks would collapse if they called in all those mortgages and realized their losses. The number of them is massive. It’s a catch-22 situation.

    You can extend and pretend and let the banks pretend to be making money on mortgages or destroy your economy by having a collapse.

    Check out Lewis Ranieri, the founder of the modern mortgage, and notice the terror he has of that prospect.
    http://www.cnbc.com/id/15840232?video=3000007154&play=1

  5. Matt Says:
    February 24th, 2011 at 12:15 pm

    JLP,

    Liberal though I may be, I’m about 50/50 on this. I fault banks for irresponsibly lending and now refusing to work with the government on a fix, but I fault borrowers just as much for foolishly buying more house than they could afford. The only reason I would argue in favor of this kind of mod is because I fear the long-term economic prospects of allowing so many foreclosures. I understand the free market principles of it, but the reality would mean thousands of homeless people on unemployment, welfare, temporary housing…it’s a pay now or pay later scenario, and I think I’m more in favor of pay now.

  6. Matt Says:
    February 24th, 2011 at 12:20 pm

    And hey, let me throw a question out to the crowd that’s been borrowing me, because I truly don’t understand it: what’s so bad about being under water? As it’s been explained, it’s supposed to be an awful thing if your mortgage exceeds your property value, but isn’t that just a short-term dilemma? As you continually decrease principal through payments and property values rebound upon reassessment, doesn’t this obviously go in the other direction? Granted, this is on a 10-15 year timeline, but I guess what I’m asking: is the under water problem only REALLY a problem for property speculators or people looking to sell their homes right now, as opposed to people like me who plan to never sell their home? What am I missing here?

  7. RA Says:
    February 24th, 2011 at 12:33 pm

    Being underwater is not a problem if you are only underwater by 5 thousand or 10 thousand. But when you are underwater by 50% or $100,000 or so, that’s a big problem.

    The people that are underwater are REALLY underwater. All they have to do is make a business decision to walk away. From an economic point of view, that makes more sense. Why would someone want to pay 100% more for a house when they could just walk away?

  8. BG Says:
    February 24th, 2011 at 12:44 pm

    Matt) There isn’t an immediate threat to someone underwater on their mortgage. However, the more underwater someone is, the higher the chance of defaulting — which is what people are doing.

    And when these people default, they should go into foreclosure proceeding as dictated by their mortgage contracts. But with the government meddling — the contracts aren’t being followed. Foreclosures are delayed with ‘payment modifications’ and other such games. For people to qualify for the ‘government meddling’, you have to actively be in default, which leads people to intentionally defaulting in hopes of some sort of bailout (mortgage modification).

    But to get back to your original question: no, there is nothing immediately bad about being underwater unless: 1) you need to sell, or 2) you want to refinance. Being underwater traps you in your house and removes your options.

    Financially though, would you rather stay in a house that you financed for $1million, and it is currently only worth $600k? If you ‘strategically default’, then: a) you will likely be able to live in your house for 6-12 months (rent free) before having the sheriff kick you out, and 2) once you are kicked out, you can buy the equivalent house for $400k less than the original purchase price.

    The main crux of the problem is that the mortgage contracts aren’t being enforced, due to government meddling. The winners are the people who ‘strategically default’ and live rent free for months, and the banks (and probably tax-payers) are funding those winners.

  9. JLP Says:
    February 24th, 2011 at 1:13 pm

    Matt,

    That’s an excellent question. Being underwater, as long as you don’t have to sell, is only a concern because people feel uneasy about the situation. People have always read, been taught, or have assumed that you buy a house and it appreciates in value while you are paying it off. When that doesn’t happen, people get angry.

    And, since people are nothing more than grown up kids, they decide when they no longer want to play the game.

    There’s no doubt that there will be pain if we allow people to default/foreclose. But, it’s the most effective way to deal with this mess. Bandaid approaches and giving people equity will do nothing but prolong the situation. Not only that, the buyers basically get off without paying consequences for their actions. Meanwhile, those of us who did the responsible thing by buying houses we could afford are going to essentially pay these people’s bills. Afterall, there is no free lunch.

  10. Ken Says:
    February 24th, 2011 at 1:20 pm

    This is a clever redistribution of wealth.

  11. RA Says:
    February 24th, 2011 at 1:32 pm

    The ones getting away without any consequences for their actions are the banks. They are having the free lunch.

  12. JLP Says:
    February 24th, 2011 at 1:36 pm

    RA,

    Before you take that attitude, I invite you to read Thomas Sowell’s “The Housing Boom and Bust” (there’s a link to it on the right side of this page). It just might change your opinion. No, I’m not saying banks didn’t have a hand in all this. But, they weren’t the main cause either. If I had to rest the blame anywhere, it would have to be on the politicians and the borrowers.

  13. BG Says:
    February 24th, 2011 at 1:39 pm

    RA) I think the banks are absolute fearful of the current situation. There is a train-wreck amount of mortgages that are going into default, and hence the banks are probably technically insolvent right now.

    If a bank, on their own, chooses to modify a mortgage, then that is fine (just business). If a bank refuses to modify a mortgage, the government should enforce the contracts and kick those people out of the (bank’s) house as quickly as the law allows.

  14. RA Says:
    February 24th, 2011 at 1:40 pm

    I know all about his position. The bottom line is that when you make bad loans, you pay the price. That’s the way the real world works.

  15. RA Says:
    February 24th, 2011 at 2:03 pm

    BG, that would be a great solution in the ideal world. But there are probably more than 2 million people that would be foreclosed on according to the numbers I have seen. This is not just a few thousand deadbeats like people like to think.

    The stock market would drop to S&P 500 or so and Baby Boomers retirements would be kaput forever more.

    In the end, the major banks are going to have to take massive losses and probably be taken over by the govt and then spun back out ala GM. That’s probably the ultimate answer. But it ain’t gonna happen. We live by the Golden Rule in the USA. Them that has the gold makes the rules.

    We just have to hope that Ben Bernanke can pull off his attempt to restart the economy by propping up the stock market and bailing out the banks because that is both the Republican and Democratic solution. It’s working fairly well so far. We’ll see if it lasts.

  16. Mark Says:
    February 24th, 2011 at 2:56 pm

    @BG: You said “If a bank, on their own, chooses to modify a mortgage, then that is fine (just business). If a bank refuses to modify a mortgage, the government should enforce the contracts and kick those people out of the (bank’s) house as quickly as the law allows.”

    That makes no sense to me. If the bank is dumb enough to let someone sit in a house and not make their payments, why should the government get involved at all? It is up to the BANK to enforce the contract by going to court and foreclosing.

    Of course, if the bank just happened to have been too sloppy to do the paperwork right, then let them figure out how to get their money back.

    A mortgage is a contract between two private parties and the great strength of the American capitalist system is a well-established system of law related to property rights and contracts.

  17. Jack Says:
    February 24th, 2011 at 4:04 pm

    “It is up to the BANK to enforce the contract by going to court and foreclosing.”

    The courts ARE part of the government.

  18. Evan Says:
    February 24th, 2011 at 4:19 pm

    RA,

    “The bottom line is that when you make bad loans, you pay the price. That’s the way the real world works.”

    So what are you saying that the banks should foreclose? and probably get pennies on the dollar I think that was JLP’s point.

  19. Harm Says:
    February 24th, 2011 at 4:30 pm

    The attitude that defaulting on a mortgage
    on a house that is currently ‘underwater’ is
    OK is part of the attitude of instant gratification
    that people have nowadays. “It must be someone
    else’s fault, so let someone else take care
    of it. I DESERVE this house, so I’m going to
    live here whether I’m paying for it or not.”
    What is MY stake in this? I’m foregoing about
    $1000.00 a month in interest on my savings
    because the GOVERNMENT is holding down interest
    rates to ‘help’ underwater homeowners.

  20. Harm Says:
    February 24th, 2011 at 4:33 pm

    And yes, the banks ARE partly to blame,
    because stupid bankers have the same attitude.
    “I’m going home at the end of the day and
    don’t have to think about the people I’ve
    hurt by not doing my job competently…..
    now where did I put that video game console?”

  21. RyanLoos Says:
    February 24th, 2011 at 4:51 pm

    Let the free market take over. This is getting to be enough. Every bailout or principal reduction ends up costing us the tax payers money. Let the free market handle it!

  22. RA Says:
    February 24th, 2011 at 4:59 pm

    Evan,

    The banks can foreclose or not foreclose. They are pretty much set either way. On one hand, they lose money and the govt covers them for their loss or swallows it up with Fannie Mae. One the other, they can pretend the mortgage is current and book the interest as profit.

    If they do too many foreclosures, they will have to recognize their losses which will overwhelm their balance sheets. That’s why we are extending and pretending and hoping things work out.

    I don’t really know how the whole foreclosure thing ultimately gets worked out. It’s a no win situation. Given that the govt is funding the banks, I don’t have a problem with principal reductions although that is not fair to current homeowners. But it is not fair to any of us to subsidize the banks losses.

    In order to keep the property markets from tanking, it is probably better to go with principal reductions. I’d rather subsidize ordinary people than banks.

    One of the most well respected banking analysts is predicting that 1 in 4 people will ultimately default on their mortgage. Better figure out a way to get that worked out if that comes to pass.

  23. Matt Says:
    February 24th, 2011 at 5:21 pm

    The more I think about this, the more I think principal reductions really are the smarter, more efficient way to do this. If you have foreclosures (and we really are talking about something on the order of hundreds of thousands of properties), you have circumstances where banks functionally turn into realtors who lose millions or billions of dollars. Banks don’t want to sell houses; carrying inventory is expensive, so they’ll offload vacant properties to speculators who will flip them for profit. And, of course, those speculators will need capital to do this…uh oh. I’m created a tear in the space-time continuum.

    Anyway, as Raneiri pointed out, you have “free market” principles and you have political realities. Those of you who evangelize on free market should know that there is NO SUCH THING as a true Adam Smith free market: there is no liberal entrance and exit, no perfect information, and there will always be some degree of state intervention or control. A free market is only a philosophical construct, so to shout “FREE MARKET” from the rooftops completely ignores the fact that millions of people will be put out on the streets, you WILL pay for it through either unemployment insurance and/or welfare, and your own property value would plummet because half your neighborhood would empty overnight.

  24. BG Says:
    February 24th, 2011 at 5:47 pm

    My point is: if the government got out of the way and banks foreclosed on people fairly quickly (3 months or so), then you will see a lot more people actually paying their mortgage.

    Right now, there are a ton of people not paying their mortgage because they know that they can get away with it (not be kicked out), and in fact might get a bailout. Currently, it is in everyone’s best interest to start defaulting (because you might get a bailout).

  25. RA Says:
    February 24th, 2011 at 5:58 pm

    BG, I think you are suffering from JLP’s fantasy that most people can pay their mortgage but just don’t want to. 19% of the United States is unemployed or not fully employed. They can’t afford a mortgage. There are 5 people applying for every 1 job opening.

    There are some people that are just walking away but those are the vast minority.

    Because the stock market is up, people think this thing is almost over. It’s actually only just beginning. The worst is still yet to come when it comes to the housing market. The meltdown was over the fear of the future. Not something that had happened yet.

    If you want to stop people from walking away from their mortgage, the best thing to do is to go Europe and not allow it to be discharged. Then we can make the whole country slaves to the banks like Ireland. It’s not as though we aren’t already. But at least, you could punish people for the rest of their lives for the mistake.

  26. BG Says:
    February 24th, 2011 at 8:59 pm

    Ray) With the guarantee of losing your home after 3-months of no payments, we would quickly find out how many people actually can’t afford their mortgage.

    Besides, for the people who truly can’t afford to pay, after they exhaust their savings, they can qualify for assisted living and live in an subsidized apartment in the ‘hood.

    I really don’t see why any effort should be spent on people who live above their means (don’t make house payments).

  27. Matt Says:
    February 24th, 2011 at 9:20 pm

    BG: What about the average middle class person that just loses their job and can’t find one for 12 months or more? What about the family devastated by crushing medical bills? What about the people living in Elkhart, Indiana; Wilmington, Ohio, or any other city that just had its major industries vanish? What if all those people had significant savings, and always lived within their means, except, you know…life happens?

    Frankly, your “hood” comment is remarkably insulting, not just to those families that actually need to take advantage of subsidized housing on a long-term basis, but also to those people who never thought they would need to but suddenly find themselves in dire straits.

    I wish only good things for you, because I don’t know that you could handle years of famine should they occur. I just hope you don’t ever need to ask for help from someone like yourself.

  28. Stacey Says:
    February 25th, 2011 at 12:55 am

    Would a loan modification work where the pmts are reduced 20-30% and said pv’d reduction put into a 2nd mortgage (balloon) that would kick in upon sale of said home or tacked onto the end of the original term. Then people have more wiggle room during the month to pay, but the bank gets a toehold if the property changes hands. The “moral” (no, I don’t want to delve into 55 comments on this) obligation is upheld, while trying to help people while they get on their feet/adjust to their new reality.

  29. BG Says:
    February 25th, 2011 at 9:04 am

    Matt) There are already safety-net programs to help people who are really struggling: assistant living and rent-subsidies.

    If something bad happened to me, I could support myself, and meet all my obligations for probably 3 years: by first exhausting my cash saving, then burning through my retirement savings, and selling assets, etc.

    After those three years, I would be dead-broke — and guess what: if I still haven’t found a job, then why should I expect to stay in a nice neighborhood?

    Stacey) I think loan/contract modifications are OK, but not when the government FORCES it.

  30. Mark Says:
    February 25th, 2011 at 10:14 am

    I think the government need to step aside and let private enterprise work. No bailouts for banks OR “homeowners”.

    Let the banks decide whether it is in their best interests to do a principal reduction, foreclose, refinance, forgive past interest due, or do absolutely nothing.

    And let them and their shareholders live with the consequences of their decisions.

  31. Mark Says:
    February 25th, 2011 at 10:16 am

    @Jack “The courts ARE part of the government.”

    What’s your point? The courts would be enforcing contract law. That is a legitimate use of government and a far cry from making policy and assigning bailout money.

  32. Mark Says:
    February 25th, 2011 at 10:20 am

    @RyanLoos ” Every bailout or principal reduction ends up costing us the tax payers money. Let the free market handle it!”

    You are flat-wrong. A principal-reduction costs the government nothing unless the government bribes the bank to make the reduction (i.e., covers their loss). If the bank makes a principal reduction as a business decision, the bank, and specifically it’s shareholders, loses the money.

  33. BG Says:
    February 25th, 2011 at 12:28 pm

    Mark) The subject on the table is:

    “The Obama administration is trying to push through a settlement over mortgage-servicing breakdowns that could force America’s largest banks to pay for reductions in loan principal worth billions of dollars.”

    So the government is trying to FORCE banks to eat principal reductions — instead of having the government (through the COURTS) enforce the existing mortgage contracts.

    This real issue is: We are losing the basic tenants of contract law in this country. If we lose contract law, then the US will essentially cease to exist.

  34. Lysander Says:
    February 25th, 2011 at 2:38 pm

    it seems like in either case both the government and the lenders lose, it just isn’t clear who will lose more and in which case.

    The issue with principal write-downs by banks is that they have to account for the loss at the time they take write-down as opposed when they (the bank)finally sells off the foreclosed property.

    It isn’t good for society (in non-financial terms), the bank, or the overall economy to have what could be up to 20 or 25% of all the houses go through foreclosure.

    At the same time, the banks can’t afford to just write down existing mortgage values by what ever amount/percent local house-values have fallen by. Let alone trying to find a measure for deciding which house should get write downs without punishing responsible borrower and/or not actually helping troubled borrower. On top of that it won’t do any good if those people can’t afford to remain in the houses anyway.

    I’m not sure which option is “better”, but i know that either are “good” – it seems to be a case of selecting between the lesser to two evils.

  35. Matt Says:
    February 25th, 2011 at 3:43 pm

    @BG: “If we lose contract law, then the US will essentially cease to exist.”

    Wow, hyperbolic much? And again, I don’t quite buy the economic argument against principal reductions. The write-offs on foreclosures would be catastrophically higher than they would be with principal reductions. Banks are not realtors, but that’s what they’d become if they foreclosed tomorrow on everyone. And they would be BAD at it. The capital is unavailable to those who would seek to purchase the increased housing stock, even as an investment, and so you know what you’d end up with? A nation of Detroits. Street after street with one or two occupied properties.

    As a responsible homeowner, am I happy that my neighbor might get a partial free ride? Not really. Am I happy that I won’t be living next to a vacant property for months or years, or wake up one morning and see my friend’s belongings on the curb as a sheriff enforces a foreclosure? YEP.

    This mantra of “Government bad, free market good” is an obtuse, oversimplified, bumper sticker of an idea.

  36. Kirk Kinder Says:
    February 25th, 2011 at 4:10 pm

    @Matt

    Wanted to address your two main points. Your first question was if negative equity is really that bad. No, it isn’t. As you rightly point out, people pay the principal down and hopefully the market eventually moves back up. However, the reality is if you bought a house for $300K and it drops to $200K, you have a big problem. That $300K really costs you close to $600K when you factor in inflation. It is much easier to default and buy back in a few years at $200K. Then your total costs are closer to $400K than $600K.

    Second, principal reductions is a horrible idea. You will find that everyone who is underwater will then default to get the principal reduction. I know I would. Why pay your mortgage for an underwater property when your neighbor gets a $100K gift. Foreclosure actually prevents people from defaulting. Most people don’t want to experience a foreclosure and keep paying to avoid it. So the banks can lose principal for the homes that foreclose or do a principal write down for all the underwater mortgages. Banks have a better chance of staying afloat foreclosing on 7 million homes than reducing principal on 55 million homes.

  37. Matt Says:
    February 25th, 2011 at 4:34 pm

    Kirk: All good points, but I think they rely on a lot of assumptions, too. A “few years” after foreclosure is actually 7-10, unless you can gin up a straight cash buy, and even THAT assumes that credit criteria will stay the same in a decade. Second, you’re apparently assuming in the short term that property values stagnate while inflation runs wild. That’s in conflict. Finally, I still don’t understand why you would think that flooding an impossibly tight credit market with never-before-seen levels of housing stock would be a more economically viable idea than marginal write downs. It doesn’t seem to consider the negative externalities of foreclosures on the magnitude that would occur and the costs associated with those externalities, most of which you could avoid with principal reductions.

  38. BG Says:
    February 25th, 2011 at 5:31 pm

    Kirk) well said.

    Matt) Why does ‘the government’ need to change anything at all? Everything we are going through is already covered by plenty of safety-nets and existing laws.

    Contracts must be enforce, period.

    If homeowners can’t pay bills, they should file for bankruptcy and have debt restructured. If they still can’t afford their house, they should be removed from the property so someone who can afford the house can buy it. If you can’t afford even a tiny apartment, you will qualify for rent-subsidies, etc.

    We do not need to be giving these dead-beats a free ride by forcing banks to handout principal reductions.

    You seem to think you know what is in the best interests of the banks — how about everyone get out of the way, and let the banks make their own decisions. If a bank thinks it is good business to reduce principal, then good for them. If not, the bank should be given THEIR PROPERTY as quickly as the possible so the bank go do with it as they please, be that dumping it on the market, or renting it out, or burning the place down — it is THEIR PROPERTY.

    As I said, this is all about contract and property law. Without it, you have anarchy.

  39. Jack Says:
    February 25th, 2011 at 5:38 pm

    M> If the bank is dumb enough to let someone sit
    M> in a house and not make their payments, why
    M> should the government get involved at all? It
    M> is up to the BANK to enforce the contract by
    M> going to court and foreclosing.

    J> The courts ARE part of the government.

    M> What’s your point? The courts would be
    M> enforcing contract law.

    The only way a bank can enforce a contract is through the government — the judicial branch. THAT is why the government needs to be involved.

    If you say the legislative and executive branches should not be involved, then we would be in agreement.

  40. Jack Says:
    February 25th, 2011 at 5:39 pm

    It is my sneaking suspicion that the executive branch wants principal reductions because those reductions are taxable income!

  41. BG Says:
    February 25th, 2011 at 6:19 pm

    Jack said: “It is my sneaking suspicion that the executive branch wants principal reductions because those reductions are taxable income!”

    Maybe they’ll get a ‘tax-due reduction’ if they refuse to pay their taxes too….

  42. Jack Says:
    February 25th, 2011 at 11:04 pm

    When asked whether I own my own home, I say, “No, the bank owns it — I own a mortgage.”

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