A New Look at Mortgage Loan Modifications in the United States

Sources:

WSJ: States Push Banks to Fix Foreclosure Process

WSJ: Banks Face More Loan Write-Downs

BusinessWeek: States Test Mortgage Principal Write-Downs

More than 25 percent of all mortgages in the U.S. are "under water," which means that those mortgage holders owe more on their homes than what the homes are worth. A synonymous term is "negative equity." Some experts have identified negative equity as the biggest obstacle to the U.S. housing market’s recovery. Borrowers with negative equity in their homes have little incentive to stay current on their mortgage payments even if they are not experiencing financial hardship. Of course, it is much more difficult for homeowners experiencing financial hardship to justify their struggle to meet their monthly loan repayment obligations on their underwater mortgages. Some U.S. financial institutions have modified, though reluctantly, mortgage loans for homeowners in financial dire straits by reducing interest rates, increasing loan repayment periods, and even waiving overdue interest. The only thing most banks decline to do is write down the outstanding principal.

Banks advance several arguments in opposition to principal reduction. Doing so would force them to take losses, which would erode their capital reserves. Principal reductions would also result in lower profits. Most importantly, banks argue that principal write-downs would only encourage more defaults because borrowers would have an incentive to stop making their mortgage payments in hopes of negotiating better loan terms.

Not all experts, however, share the banks' concerns. On March 3, 2011, state attorneys general and several federal agencies sent a proposal to some of the major banks in the U.S. that may require the banks to reduce mortgage principals for distressed borrowers. This proposal does not impose any fines or penalties on the banks. Rather, it focuses on the ways banks should treat borrowers seeking loan modifications or facing foreclosure. Some of the features of the proposal would require banks to deny in writing loan modifications before referring homeowners to foreclosure, to provide distressed borrowers with contact information for a single employee assigned to their case, and to consider reducing the principal on underwater mortgages.

Up to this point, very few mortgage modifications have involved principal reductions. For example, the U.S. Office of the Comptroller of the Currency reported that only 4 percent of the loan modifications done in the third quarter of 2010 involved principal reductions. Since banks have tried, with little success, almost every other available tool for preventing foreclosures, some experts believe that reducing loan principals is the next logical step. Ocwen Financial, an Atlanta-based mortgage lender, estimates that homeowners whose mortgages have been modified without a principal reduction are almost twice as likely to re-default as homeowners whose modifications involved principal reductions.

Some of the states with the highest declines in home values, such as California, Nevada, and Arizona, are already experimenting with principal reductions. The U.S. Treasury and the banks that own the loans share the cost of these mortgage modifications. No more than 40,000 borrowers are expected to benefit from these pilot programs. Experts point out, however, that although the proposal may not help many borrowers, it will yield data to help banks and the Government evaluate the effectiveness of mortgage modifications involving principal reductions.