Saturday, July 11, 2009

Why Lenders Don’t Do Principal Writedowns

If only lenders wrote off principal on loans in default, our problems would be solved. Gretchen Morgenson  on her New York Times article So Many Foreclosures, So Little Logic:

If banks have written down the value of these loans to the 40 cents on the dollar that they are fetching on foreclosures — the only true value for these homes right now — then why don’t they bite the bullet and reduce the loan amount outstanding for the troubled borrowers? That type of modification would be far more likely to succeed than larding a borrower who is hopelessly underwater with yet more arrears.

And today The Big Picture quotes Mark Hanson of Hanson Advisors (via Barron’s) on why loan mods are not the answer:

Loan mods are designed to keep the unpaid principal balances of the lender’s loans intact while re-levering the borrower. Mortgage modifications turn homeowners into underwater, overlevered renters for life, unable to sell, re-buy, refi, shop or save. They turn homeowners into economic zombies.

The belief that principal writedowns somehow solve a problem that other types of modifications can’t is wrong. Overwhelming, loan defaults are caused by income curtailments – the borrower loses a job, households break up, people become ill (long post on this topic with additional links here). Such situations have two characteristics; (1) they are binary, in the sense that a borrower goes from being able to make a full payment to being able to make only a drastically reduced payment, or no payment at all, and (2) they are often temporary. These are the cases where lenders typically offer repayment plans which allow unpaid installments to be repaid over time, with the result that when the forbearance period is over the payments go up. Sometime that works, and when it doesn’t a different form of relief is necessary. But it would be just crazy for a lender to offer a permanent, irreversible principal reduction in these cases.

For those cases where a long term reduction in the payment amount is necessary, let’s look at the numbers. Let’s suppose the value of the property today is 50% of the amount owed:


The payment relief under these two structures is identical, so each borrower is in the same position to save and spend, and each is as likely to default if there is a further decrease in income. Each borrower can move if they want to: either can just walk away, or negotiate a sale with a buyer. In the case of the borrower with the payment modification, it will be a short sale, but lenders do those all the time.

There are really two issues. The first is a classic principal-agent problem; the borrower knows their true financial condition and is in a better position to know the value of the property than the lender. Lenders are understandably reluctant to lock in a loss under these circumstances. The second issue is, who gets the upside if the property is worth more than $200,000 or the value increases later? It’s the borrower with the principal writedown, the lender with the modification. Lenders are reluctant to give up the upside, because debt is supposed to be paid before the equity holder.

Please note, I am not saying that lenders are doing a good job of modifying loans (just the opposite; see Mortgage Modification Blues, for example). But, is there any reason to think lenders would do a better job processing principal writedowns? I’m saying that lenders need to get better at modifying loans where appropriate, and principal writedowns are not the solution.