Among a slew of contenders, we pick the principal write-down provision as the most problematic in the term sheet released last week in the mortgage-servicing settlement talks. If full-bore principal write-downs are required, we’ll have realized one American dream of homeownership: you’ll get to buy a house, take out a mortgage and – when you don’t want the house anymore – you can give it back.
The premise of principal write-downs is that there was so much predatory lending that borrowers deserve protection when house-price depreciation leaves their loan-to-value ratio under water. There was of course more than too much predatory lending in the run-up to the crisis, and some borrowers took out high-LTV loans because they were suckered into the no-money-down, you-can-have-it-all products being pushed with nary a care for sustainable home ownership. Vulnerable borrowers were also scammed into cash-out refis that levered up their LTV, often only so that they could then buy dubious home improvements from the helpful friend associated with the enthusiastic mortgage company.
But, how many of the eleven million or so borrowers with under-water mortgages are true victims? For every one of them, there may well be ten borrowers who used their homes as the proverbial ATM, using cash-out refis for fun toys or investment “opportunities.” And, lots of “home” mortgages aren’t – a recent study found that about 25 percent of mortgages represented as “owner-occupied” are in fact investment properties. Should borrowers get principal reductions so that their flat-screen TV or boat now is free? What about investors who lied when they bought a condo they thought they could flip in Vegas before anyone got wise?
In theory, it’s possible to pick between the deserving and the profligate in providing principal write-down. Indeed, in practice, some banks are already doing it. BofA, for example, just announced that it is providing principal write-down loan modifications for military servicemembers – or, at least some of them. Even here, there are deep divides between some military borrowers who don’t feel like paying their mortgages and those servicemembers and their families who can’t pay their loans because of unique factors applicable to this group: a wounded warrior or worse. For good measure, the law here is different, with servicemembers due an extra measure of protection too many banks forgot about.
But, what to do for most borrowers if principal reduction doesn’t generally apply? Go back to letting HAMP help as many borrowers as it can while banks continue to unclog their overwhelmed servicing platforms? That won’t happen, much as many in the Administration and the industry might hope. For all the principled reasons that principal write-downs are problematic, the industry is confronting a hard reality: no one trusts it anymore. Statistics like those cited above are persuasive to those of us who read the fine print about mortgage finance. More compelling to everyone else are the case histories of borrower after borrower who not only fits the “deserving” description of a victimized customer, but whose efforts at loan modification have also been stymied by obdurate servicers with an amazing knack for losing all relevant documentation at each turn of the foreclosure process.
As a result, we think a reasoned approach to principal relief is required. The industry knows when principal reduction – including that related to second liens – ensures long-term sustainable mortgage payments and when, in contrast, it will just promote “strategic defaults” (the term rightly used for borrowers who just aren’t in the mood to repay an under-water mortgage). The problem isn’t lack of analytics, it’s the same systems problems that have caught deserving borrowers in Catch-22 loan-mod land: servicing systems are grievously overwhelmed. As a result, principal reductions that truly promote sustainable home ownership without creating a new form of moral hazard are rarely offered and, when they are, usually put on the table way too late.
A methodology for discerning the deserving from the strategic defaulters is thus an urgent priority. Banks have it, but haven’t deployed it to much effect in advance of the servicing settlement. Their credibility shredded as it’s been, servicers may now not get to put this methodology into practice. Instead, they could be forced into the blunt-edge principal write-downs described in the draft term sheet.
That would be a grave blow not just to the near-term recovery of mortgage finance. The longer this crisis lasts, the harder it will be for residential finance to normalize. Worse, though, the more institutionalized the promise of principal write-down and the less discriminating the offer of it, the more mortgages will come to look like credit cards. Buy the house, wear it for a while and return it.