There are many challenges associated with principal reduction as a tool to heal our ailing housing market. Many concerns are raised when this type of loan modification is being contemplated.
Which homeowners are most qualified and deserving of receiving a principal reduction? Should it be one that is underwater, remaining current but may be a future strategic defaulter, or a delinquent homeowner who is actively seeking a means to avoid foreclosure? Is principal reduction a “moral hazard” inadvertently rewarding homeowners that made a bad decision?
Before we throw principal reduction over the fence as an impractical solution to the foreclosure tsunami, let’s review the latest grim statistics. William Dudley, the president of the Federal Reserve Bank of New York, recently spoke at a meeting of the New Jersey Bankers Association.
Dudley estimated 5.6 million homes will be foreclosed upon by the end of 2013. Dudley also predicted an estimated 1.8 million homes will enter foreclosure in both 2012 and 2013.
This is not a situation that can be solved by waiting for the market to correct itself. Unfortunately, it is impossible to repair the damage that has already occurred. But, there is hope that maybe the future estimates of an additional 1.8 million foreclosures can be mitigated.
Laurie Goodman, senior managing director at Amherst Securities, is a much sought after industry pundit on housing reform. Goodman has extensively researched loan modification programs, both governmental and private, with a focus on identifying who defaults, what efforts are made to save borrowers and how best to reduce investor losses.
Her research revealed that most programs that did not provide a principal reduction modification produced only negligible results. These programs, which typically involved a reduction in interest rates and/or an extended payment schedule, did not address the root of the problem, which was the borrower’s overall debt load. According to CNN Money, “Goodman found that investors lose as much as 70% when the homes underlying their subprime mortgage backed securities are foreclosed upon.”
Lenders that engaged in principal reduction loan modifications, with an average reduction of 26%, were far less likely to foreclose, thus yielding investors a higher average return. Goodman may have summed up the bottom line issue when she stated, “If you save a borrower, you save an investor.”
How then can principal reduction be effectively implemented? One approach showing promise is a shared appreciation mortgage modification. This type of program provides a principal reduction in exchange for shares of any gains on the home when it is ultimately sold.
This type of program has been endorsed by the Treasury Department, Nouriel Roubini, a noted New York University economist, and several state attorneys general.
Vetting homeowners for a principal reduction modification may require more analysis to assure they are a good candidate, but the potential gains far outweigh the losses. Ultimately, principal reduction modifications may prove to be a proactive step in restoring stability to the housing market.
Diane Gozza is executive vice president, business development, Integrated Mortgage Solutions, Houston.