Wednesday, March 04, 2009

Why not just reduce the principal?

Details of the Obama plane to help mortgage borrowers were released this morning. The order in which the mods will happen: interest rate reduction, term extension, principal reduction.

This is backward. Suppose a $100,000 loan has a 7 percent coupon, and its rate is modified down to 4 percent. The payment drops from $665 per month to $477 per month. This helps, but leaves the borrower underwater, making it difficult for her to sell if she needs to move to a new job.

But a $477 payment, at 7 percent annual interest, has a present value of $71,759. So if the interest rate remained the same and the loan balance was written down by 28 percent, the payment would be the same as an interest rate write-down to 4 percent, but the borrower would have her head above water. If she later sells for more than $72K + selling costs, she can split the proceeds with the lender, who would now basically be a shared equity owner.

I think the people in the Obama Administration are very smart. Why aren't they doing this?


Nathan said...

What happens when the borrower refinances at the prevailing 5% interest rate after the principal is reduced?

Since they are no longer underwater, they may be able to refinance and the original lender will be out 28% of their investment, not to future interest earned.

PS, Love the blog! Agree or disagree, it's fantastic insight and often brilliant ideas

curiouscat said...

good post and comment. I agree with (in some instances) partially reducing the principle and partially reducing the interest rate. But a principle reduction probably has some political (v. economic) implications. I might be wrong but I think political considerations are part of the problem with principle reductions.

The principle reduction makes some sense to balance the needs of the lenders and borrowers. The borrowers can benefit more from the principle reduction (by selling early). The lender from the opposite (assuming the same net present value) - for the same reason, an early sale provides them more benefit if the principle is not reduced.

JohnDoe said...

Because the people holding the paper want to delay losses as long as possible. In foreclosure losses hit the bottom tranches first. In principal reduction, all tranches get hit.

Anonymous said...

how would you explain this great deal tgo people who do not currently own homes? you will be able to buy a cheaper home later beacuse you tax dollars are going to underwrite the mortgage and related securities for the banks and irrespopnsible borrowers?

JB said...

The worry that borrowers would simply refinance to a lower rate is a simple fix: require a 2 year soft pre-payment penalty that would not allow them to refinance the house if they accept the principle reduction.

The real problem with principle reduction is that it has a direct impact on local house prices in the area. Home sales are based on appraisals of similar properties. If you mark down the principle by 30%, you're sharply increasing the speed at which house prices are declining in a neighborhood, and you increase the risk to your portfolio of houses in the similar neighborhood because their Loan-to-value will all fall (due to a lower value). Lowering interest doesn't affect LTV or future appraisals. It also affects other contracts like homeowners's insurance, local property tax liabilities, etc.

I think the easiest way to ease the pressure is simply to lengthen the years of the bond. Switching a 30-year loan to a 35 or 40-year loan lowers monthly payments without affecting either the principle or the interest rate. It certainly lowers the value of the loan, but the intrinsic value is already less; a longer time period is an easy and quantifiable modification to write-down.

Anonymous said...

I don't understand why a principal reduction necessarily decreases the value of other houses in the neighborhood. Doesn't it go more according to recent sales? For example, I have neighbors who are still paying mortgages they took out 20+ years ago, the principal on which is (at most) a third of what I paid for my house 6 years ago. It sure didn't have any effect on my house price when I bought.
Also, an open question: if the principal on a loan is written down, doesn't this normally count as income for tax purposes?

Anonymous said...

so i am not sure how much money you have. but lets say you have $100k in savings. and you lent it to a friend to buy a home. and now they cant pay you back. would you take the deal you just described?

or would you 1. foreclose, own the home, rent it and sell it later, 2. offer a deal where you keep all the proceeds until you get your $100k back?

common! use common sense

JohnDoe said...

A principal reduction has zero affect on the price of a home. Prices are already down and falling further. A principal reduction is a reduction of the underlying loan and in fact has nothing to do with the price. The real problem is that these loans have been sliced and diced and packaged into different securities and nobody knows who owns what. As I stated before if you own the senior tranche of this paper it is possible that even in foreclosure you may not lose much money. Meanwhile a principal reduction hits all tranches and you will certainly lose money. The bond holders are not willing to take that hit and that is why it is so difficult to implement a principal reduction across the board. That is why the current plan is only available to people whose loans are held by fannie and freddie.

William said...

My brother's comment essentially describes cram down in Chapter 11 or 13 Bankruptcy. Cram down is done with cars, boats, apartment buildings, commercial real estate, 2nd homes, motorcycles, snowmobiles etc.

No one has ever explained to me why cram down is wrong for homestead property belonging to people who work for a living and presumably do not have the sophistication or resources of those who own 2nd homes or high priced RVs.

It still stuns me that those on the right blame this problem on the people who work for a living and probably showed bad judgment in buying too much home, or signing an ARM when they couldn't afford the rate increase(of course, they were told that refinancing would be easy). All this while the banks and the mortgage brokers, who were supposed to be smarter and more sophisticated then the borrowers, pushed these loans by selling them as smart financial planning, because real estate always goes up in price, doesn't it?

I don't mean to sound like a populist, but Jesus these guys made millions of dollars while screwing the borrowers, the investors in the bonds, and the bank shareholders. It's a trifecta. Maybe greed isn't so good after all.

Anonymous said...

Just read through all this and got to the bottom where it says "It still stuns me that those on the right blame this problem on the people who work for a living"

I am on the right - we blame this on Barney Frank, Chris Dodd and the other liberal democrats who ignored the warnings that reform was needed in the lending sector. Instead the left under Carter and later Bill Clinton expanding on the Carter program of forcing lenders to make loans to people who could not afford them.

I have family members who were in the mortgage industry - they lost jobs. They sold a product that by law had to be explained to the consumer whose decision it was to sign the document to take the loan. Don't blame the lender blame the politicians that forced this on the consumer and turned the other cheek when it was brought to their attention.

Blame the education system that has been systematically reducing the education level of our people that do not teach financial literacy at all.

Don't blame me because I am a conservative - who by the way hung up on all those people calling me offering a $600 payment on a $250,000 mortgage - I can at least multiply 360 * 600 = 216000 not enough to pay off the balance! Blame those who made stupid choices for their own personal greed of a "too good to be true" mortgage payment so they could buy a house they could not afford.

Oh and I am not ultra rich, don't have a second home or an expensive RV so don't fit those wiser than me that can understand coupons at 7% interest versus principal reductions, etc. I can understand 3-4th grade multiplication to know something was not right (see the pun here since it was leftist libs causing the problems) with a "Too good to be true loan payment"

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