Underwater Home-Owers: Demand Principal Reductions

The FDIC is proposing a test program of principle reduction for negative equity homeowners.

But why is the FDIC required? An intriguing private sector solution would be a negotiated principle reduction between borrower and lender — no government intervention is needed.

Let’s begin exploring this idea by looking at a Washington Post article from today (FDIC to test principal reduction for underwater borrowers):

“The Federal Deposit Insurance Corp. is developing a program to test whether cutting the mortgage balances of distressed borrowers who owe significantly more than their homes are worth is an effective method for saving homeowners from foreclosure.

The program would be aimed at a growing population of homeowners who are underwater on their loans, estimated at more than 20 percent of borrowers, or 11 million homeowners. Economists consider these borrowers among the most vulnerable to foreclosure, and some industry officials worry that more of them will simply walk away from their mortgages, or “strategically default,” rather than spend a decade or more trying to regain positive equity.

Under the FDIC program, borrowers would be eligible for a reduction in their mortgage balances if they kept up their payments on the mortgage over a long period. The performance of those borrowers would be compared with borrowers given more traditional mortgage relief packages, such as those that cut the interest rate on loans.”

It only requires basic math skills for all parties to recognize that it is in the banks interest to avoid foreclosures. Underwater borrower with this knowledge — and the cojones — should let the bank know they understand simple math: Foreclosures = 50% bank loss.

They can then “engage in an arm’s length, Wall Street style negotiation.” Not precisely a threat, but simply laying out clearly what the mortgagee’s options are.

Imagine if a negative equity home-ower said to their lender:

“The fact is you lose ~50% (40-60%) on a foreclosure sale of a 2004-08 vintage mortgage.Since Morgan Stanley and other who have defaulted and walked away from money losing commercial real estate transactions they could not renegotiate, I am going to do the same: Unless you cut a substantial percentage of the principal (~20-30%) owed, then I will choose to strategically default (walk-away).”

I suggest bypassing the FDIC and going straight to your lender. Where the FDIC could be of assistance would be to prod the lender to consider the alternative to foreclosure.

My guesstimate is that of the 5 million probable future foreclosures, this mod would be applicable to about 20% of them. Note that a recent report from the Office of the Comptroller of the Currency implies that banks have figured this out: In Q3 of 2009, 13% of loan mods included a principal reduction, up from 10% in Q2 ’09.

Of course, if Congress didn’t force FASB tio eliminate mark-to-market on holdings, the banks wouldn’t be able to, Japanese style, wait the whole mess out over the next decade or two.

There are additional elements involved.

The HAMP approach (which isn’t working very well):

“Lenders have been reluctant to cut the principal balance owed by distressed borrowers, arguing that it would encourage homeowners to become delinquent even if they can afford their mortgage. Instead, the industry has focused on providing mortgage relief by lowering a borrower’s interest rate or extending the terms of a mortgage to 40 years.

We know borrowers do not benefit much from these mods —  a 1% lower, 40 year mortgage still makes most of these homes too expensive. It does little for the ability of the underwater borrower to carry the property. And these HAMPS fall into default at a very high rate — 60-80%, depending upon circumstances.

Final point:

“In some cases, a portion of the principal balance is put into a second mortgage that does not have to be paid off until the borrower sells the home or refinances.”

That was my 30-20-10 proposal some time ago. That is a good fall back proposal — move 30% of my mortgage into a 10 year, interest free 2nd mortgage.

A straight up principle reduction is the way to go, with a balloon mod an alternative option.

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Previously:
Fixing Housing & Finance: 30/20/10 Proposal (September 22nd, 2008)
http://www.ritholtz.com/blog/2008/09/fixing-housing-finance-302010-proposal/

Strategic Defaults in Florida (October 28th, 2009)
http://www.ritholtz.com/blog/2009/10/strategic-defaults-in-florida/

Coming Soon: 5 Million More Foreclosures (February 16th, 2010)
http://www.ritholtz.com/blog/2010/02/coming-soon-more-foreclosures/

Source:
FDIC to test principal reduction for underwater borrowers
Renae Merle
Washington Post, February 26, 2010; A20
http://www.washingtonpost.com/wp-dyn/content/article/2010/02/25/AR2010022505817.html