Bailout

Why mortgage principal reduction isn?t happening

By Felix Salmon

BofA’s “earned principal forgiveness” program looks very similar to the Responsible Homeowner Reward plan of Loan Value Group that I wrote about yesterday. In both cases, homeowners staying current on their mortgage payments get a reward after a certain number of years — a principal write-down on their mortgage in the first case, and an old-fashioned cash payment in the second.

I think I prefer the cash payment to the principal write-down, assuming that the write-down would cost the bank just as much money as a cash payment would. While the effect on the homeowner’s balance sheet is the same, most people would prefer a pile of cash to a principal reduction — especially if the principal reduction is taxable, which it might well be, in five years’ time.

There are two problems with such programs catching on, however. The first, as detailed by Shahien Nasiripour, is that Treasury’s loan-mod program seems designed to use principal reductions only as a last resort. And the second is the fact that although such plans can benefit both borrowers and lenders, that doesn’t mean that everybody ends up happy. Tom Brown reprints with approval this letter:

Dear Mr. Moynihan,

I awoke this morning to read that Bank of America intends to begin forgiving mortgage principal for delinquent borrowers. I am writing to inform you that I will never bank with your firm ever again.

Principal forgiveness is an affront to every responsible, non-delinquent borrower in your book of assets… you are rewarding those who bit off more than they could chew, while those who did not take on excess leverage, or who kept their income-to-debt ratios manageable, see no benefit, even as their home equity values have declined. Even worse, you are denying savers who sit in the cash market the opportunity to purchase inventory from the delinquent.

Capitalism should migrate assets from the weak to the strong, not the contrary… allowing those who are delinquent to now benefit from their financial excesses is a despicable solution that ignores the integrity and responsibility of those who actually finance the lion’s share of your earnings: those who don’t default.

I’m not entirely clear how banks are supposed to give their savers the opportunity to buy distressed real estate, or why anybody thinks that’s a particularly good idea. But what’s abundantly clear, not only here but in the comments to my Loan Value Group blog entry, is that the anger behind the infamous Santelli tea party rant has not gone away, and that if people hated the idea of interest-rate reductions on mortgages back then, they’ll really hate the idea of principal write-downs now.

Bankers are always on the look-out for a good excuse not to engage in principal write-downs, and this is another arrow to add to their quiver of such excuses: doing so will enrage and inflame their customer base.

Remember too that it’s pretty much impossible to quantify the upside, to a bank, of a principal reduction, since doing so requires calculating exactly how much the probability of redefault has been reduced. Bankers, as we know, like to do things that make their bank money in quantifiable ways, so that they can then show their boss how much money they’ve made, and ask for a nice seven-figure bonus at the end of the year.

For all these reasons, I suspect that BofA’s move into the world of principal reduction will remain very small-scale, and that insofar as the practice takes off, it will do so only among hedge funds and others who have bought mortgages on the secondary market. At least unless and until Treasury modifies its modification principles.

Update: WaPo is now reporting that “For the first time, the government will offer financial incentives to lenders that cut the principal these homeowners owe on primary mortgages.” I’ll believe it when I see it, although this is undoubtedly encouraging.

Full post as published by Macroprudential on March 25, 2010 (boomark / email).