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Is Bank of America headed towards principal reductions?

by Morgan on April 30, 2008

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Reader Paul (big hat tip to him) pulled a key comment out of the B of A press release issued earlier this week that addressed Bank of America’s efforts to help homeowners keep their home. The comment, burried at the bottom of the release was:

“We will continue to work with distressed borrowers to match the customer’s repayment ability with the appropriate loss mitigation option, including loan modifications, forbearances, repayment plans, lower rates and principal reductions,” McGee said. “

Paul thought it was absurd that no one pressed McGee on the last point which was “principal reductions.” This, he argued correctly, is a massive change in policy for the industry, as banks have been fighting tooth and nail to make sure that court-ordered principal reductions (cram downs) aren’t enforced from the bench.
The Implications of a BofA-led Principal Reduction Effort Would be Staggering

If Bank of America is truly making principal reductions a part of it’s “home-saving” playbook it would have incredibly wide-spread implications across not only the banking industry but the housing market and general economy.

As Paul mentioned, the press didn’t have a chance to grill him on this point and I agree with him that McGee needs to be held accountable for what he said and to outline in greater detail just what role these principal reductions are playing (or will play) in BofA’s loan modification process.

Bank of America, if they are making principal reductions even a trivial part of their options in keeping homeowners put they will set a precedent which will inexorably alter the housing market. Think of the ramifications of this action.

First of all, Bank of America’s adoption of this policy would make it essentially an industry-accepted practice overnight. Lenders of all types would gladly follow their lead in an effort to keep their REO rolls from growing exponentially. Why wouldn’t a lender take a $25,000 principal reduction if it keeps the mortgage current than risk the pain and headache of foreclosing for a property that might only sell for 50% of the current note?

The Ultimate Moral Hazard

Homeowners who are struggling with their payments due to myriad reasons (from fraudulently overstating their income to a resetting option-arm to death of the primary wage earner) will see principal reductions to keep them in their home. The homeowner next door in a comparable home will not see that relief as long as they continue to make their payments on time.

Homeowners are rewarded for feigning problems with their mortgage payments to get the reduction. It’s a less-painful version of mailing in your keys. Go down 60-days on your mortgage and get a nice chunk of your loan balance forgiven.

A Good Homeowner Gamble?

The argument that the mere idea of a damaged credit score is enough to keep full-balance folks paying right along while their neighbors get gifted $50k loses credibility in the current environment. If I’m a homeowner (which I am) and I’m current on my mortgage (yes, again) and I’m seeing all of the bail out plans and changes being made and I see Bank of America add principal reductions to their loan modification tool kit for delinquent borrowers I might start to think that there is going to be some government intervention on future credit as a result of this mess too.

Think about it – with all of the changes to save homeowners who are losing their homes and going down late on their mortgages the government will surely want to address future credit opportunities for those bailed-out. They may even be thinking of a way to help folks who suffered a foreclosure or late payments by a “resetting ARM” be distinguished in credit scoring from those who faced bankruptcy or late payments on consumer debt.

If I’m a homeowner who is seeing principal reduction around them I might trade $50,000 in debt forgiveness for a couple of years of higher interest-rate costs. Heck a back-of-the-envelope calculation might show that it’s worth it even without changes to current credit scoring methods and the laws governing same.

Is Once Enough?

Do you only get one shot at the reduction? Blown Mortgage regular Ann had this to say about the principal reduction path:

The question I have is what types of loans are going to be modified? Teaser ARMS? MTA’s? Also how do you modify? Based on True income when it was a liar loan? Principal Reductions in a declining market..does that mean that a year from now when the price goes down another 10% are those borrowers going to expect more? What about the average Joe next door, who isn’t a “troubled” borrower and now has a principal balance of $300K..while his neighbor had 50K forgiven and now has principal balance of $250K?

Seems to me there is no end in sight…

And that’s another major challenge. What happens to the neighbor who takes the write-down now, and then sees his neighbor take a write-down in six-months that is double the amount forgiven to him? Does that neighbor sue Bank of America for an additional reduction?

Where do Second Mortgages Fit In?

The questions keep going. What about second mortgages? Where do those fit in? Does Bank of America forgive debt on the second first or keep the higher-rate (mostly unsecured) second debt and reduce the principal on the first? How does that get figured out.

What did McGee Mean?

In the end Paul is right – what is Bank of America really considering with these loan modifications and principal reductions as they mentioned in their sweeping press release about homeownership. Did they “misspeak”? Were they only pointing to the options available in the entire universe of home-saving? It’s a question that needs to be drilled down on and Bank of America needs to be held accountable to what they said for the sake of all participants in this market.

What do you think?

Last 3 posts by Morgan

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  • ann
    First of all..the principal reductions are already taking place in certain markets..regardless of BofA stamp of approval..many investors who are buying mortgages on the market at a discount are already contacting borrowers to reduce the principal and get them, if possible to refi the loan so that they can collect their money..

    http://www.latimes.com/business/la-fi-loanbuyer...
  • Yes, the principal reductions are already taking place. Particularly with second mortgages. I am actually seeing homeowners being solicited to sell their home on a short sale after their mortgage has been purchased (at a discount) by another lender. The fact is that these write-downs that have taken place (and many, many more to come) are equating to 'principal reductions' on the balance sheets of these institutions. Once sold at a discount to another institution, that new holder of the loan is overjoyed when the loan is then paid off at a discount.
  • Thanks Paul - I think the interesting question is the logistics of the
    mass-adoption of this practice, which according to our commenters
    doesn't seem likely at this point, yet is still an interesting dilemma
    in its own right.
  • Good catch, Morgan. Reductions, lowered payments/interest, etc., make so much more sense from the lenders' point of view.

    I'm still trying to figure out why they're willing to amputate when a little surgery can save the limb.

    In your opinion, why are lenders apparently going against their own best interests?
  • I think the amputate mentality simply comes from the previous year's
    run up. In the past decade foreclosing on a home was a sure way to
    get it quickly sold and usually at 100% recovery or greater. So banks
    dialed in the systems to crank through foreclosures. Foreclosing is
    like building a Model T, division of labor, assembly line, no thought
    needed, crank it through the system. Loan modification, principal
    reductions, etc. require *gasp* thinking to find a better way. While
    the arguments of equitable treatment of all mortgage-holders are
    important, this is clearly as less-painful step for lenders than
    foreclosure in this current environment.

    Thanks for the comment!
  • BobK
    Bernanke spoke favorably of principal reductions as a tool, and everybody took it to mean that it was some sort of policy recommendation. But in reality, I think it's just that some economists feel that it's a better choice *for the bank* than some of the other concessions they make to troubled borrowers, such as deferred payments or reduced interest.

    Offhand, I can see that if a bank reduced the borrower's principal, it would increase their equity in the home, and thus increase the incentive to keep up payments. Of course, it wouldn't help in most cases, but I imagine there are certain circumstances where it might prevent a short sale.
  • Bob
    The key word in that quote was "appropriate". Extremely subjective.
  • Bob - I agree. I can see how a principal reduction of X dollars that
    is less than the cost of foreclosure + recovery of new sale price is
    extremely attractive to lenders at this stage in the game. I am more
    interested in the logistics of how it would play out on a large scale.
    At this point it doesn't seem likely given the responses here, but
    does pose an interesting dilemma of its own...
  • James Freeman
    I have 5 homes all maxed out with 10 mortgages, all balances on the second mortgages are greater than the value of the homes after a sale including selling costs. I can rent all 5 to cover the first mortgages including all other monthly costs at a break even, four already are rented. Additionally, all first mortgages are fixed rate 30 year low interest rate loans that average six percent. So if B of A/Countrywide would elimanate the second mortgages, I would catch up all first mortgages all currently four months (seconds behind 5 months) behind with money I have been saving from the rents collected. Then none of these properties will go up for sale that is further pushing late as well as on time paying home owners out of thier houses from rapidly falling prices or making them want to leave. I am sure such relief will be followed by certain terms, such as not being allowed to sell for 5 years or more. I was surprised to read the bailout package and there was no talk of help for homeowners, funny that wallstreet was fully informed of the help they are getting, but mainstreet has to hear it word of mouth or through internet searches.
  • Morgan, servicers have been forgiving debt in rare cases for some time now. In October, at the Mortgage Bankers Ass'n convention in Boston, a Countrywide exec, speaking on a panel about loss mitigation, said that Countrywide was approving some principal reductions. None of the other servicers batted an eye. I asked the Cwide guy about it afterwards, and he said principal reductions were rare, and that there had been no change in policy. I've looked for people who've received principal reductions or short refis, and haven't found any who are willing to talk about it for attribution. I don't think the BofA thing is much to get excited about.
  • Thanks Holden - It will be interesting to see if it becomes a
    more-formalized tool or not. If it does, of course, many of the
    questions still need to be answered, if it is an arcane,
    back-room-deal type option that you never hear about it becomes of
    less import and just a curious by-product of the housing bubble.
  • BobK
    Yeah... I think a lot of folks heard that testimony and immediately thought of some sort of government policy (perhaps including certain Congresspersons... it's always dangerous to give them bad ideas).

    But I interpreted Bernanke's comments simply as advice to the banks, suggesting they reconsider something that had historically been anathema to them. Probably a lot of economists within the banks had similar ideas, but until somebody in Fed/Treasury had given it credence, banks were unwilling to risk it.

    (oops... replied to the wrong thread... sorry)
  • Morgan, are there tax implications for a mortgage reduction?
  • I think there are. I believe it would be similar to the implications
    of a short-sale. A 1099 may be issued for debt-relief by the company
    providing the relief. I'm not a tax expert though - so definitely
    talk to a certified accountant or other tax expert.
  • Bush signed a law late last year called the Debt Relief Act, and it removed the tax on forgiven debt in short sales and short refis (refis with debt forgiveness). I can't remember for sure, but I think this tax provision is temporary.
  • drumfast00
    Not everyone has the opportunity to maintain a healthy mortgage. People are worse off, than when they started their current mortgages. This downward hinge is obviously effecting millions. You cant put the blame on higher cost of living to the homeowners who, now, cant keep up with previously do-able payments. I agree that giving a handout to deliquents is unfair to those keeping up. Yet, is it fun to watch the rest of your neighbors suffer, as you grill your steak to its regular perfection? I'm sure the smell is very potent to the neighbors sitting in the driveway managing the yard sale of things they dont really want to rid of. Think about it, the future of all of us, doesn't always have to revolve around the privaleged few. (sorry for the spelling)
  • I agree - I don't think it should be centered on the privileged few, I
    just don't understand why those that can actually pay their mortgage
    (especially if they've put money down, used fully-documented income,
    etc.) are penalized vs. those that lied about their income and
    over-stretched expecting their home to go up. I just want any actions
    to be as equitable as possible.
  • drumfast00
    For sure. Its hard to accept its becoming a have and a have not world. The whole damn thing needs to be re arranged. Starting from its source. What source is that? I sure wish I knew. haha.
  • I think the best way forward for everyone is for the Government to subsidize
    low interest fixed rate SHORTAGE loans. This is the most responsible way
    to help out those who find themselves unable to pay a way out of thier homes
    with viable options that do not hurt the economy an present a "Moral" Hazard.

    A Solution to stop the bleeding in the Housing Industry-
    Government Subsidized Short Loans.

    For those who bought home in the past 5 years or have an adjustable loan that will reset sometime in the next 5 years.

    In order to stop the precipitous decline in the housing industry government needs to provide subsidized "Short" loans for the difference between what a homeowner can sell there house for and the amount the homeowner actually owes. This loan will provide rates the homeowner could receive on a regular home equity loan for up to $100,000

    This will allow homeowners to reevaluate their financial positions to more fiscally sound situations if necessary. As it stands now homeowners with good credit have no other choice than to wait until home values increase before they can have the freedom to seek other housing accommodations.


    How would this work:


    Homeowner A house's current value is $200,000 he owes $250,000.

    His payments are about to reset from 4.8% to 7.0%

    That’s a payment of $1467 to $1664 and he can't afford it.

    Homeowner A sells the house for $200K

    Now He Has Options:

    Option A:

    He gets a loan from the government for $70K at 7% that’s $465 a month.

    He finds a smaller place for sale at $150,000 puts 20% down from the government loan.

    He gets a mortgage for $130,000 at 6.5% and pays $839 a month.

    Now Homeowner A is paying $1,304 a month on a mortgage the will not reset. That’s a saving of $163 a month in the mortgage payments.

    Option B:

    Continue to pay off the government loan of $50K and find a place to rent.

    That’s $333 a month plus rent he can afford to rent an apartment for $1,134


    The Benefits of Government Subsidized “Short” loan?
    This will allow homeowners to pay back the shortfall without damaging their credit.
    Also, by stabilizing hundreds of thousands of homeowners the economy will benefit.
    As it stands now homeowners have few viable options that only will exasperate the decline in the overall economy.
    Stop the decline of housing prices
    Extend more help to a greater amount of homeowners.
    Keeps the homeowner from transferring debt to government and lenders.
  • Jill
    Certainly someone must be approaching McGee to pin him down on what he has said? A call to journalists!
  • I see a number of problems with the whole idea but two really pop up.. first if this becomes the "norm" I would suspect we will see the demise of the 30 year note. No one will want to make any loan of that length with the possibility of losing 10-20% of the principle without a huge increase in rates.

    Secondly the government is penalizing those who are financially responsible. I expect the backlash to really heat up from owners/buyers who are prudent.
  • Cheryl
    I have a fraudulent mortgage loan with Bank of America. It was supposed to be a Fannie Mae reduction loan and after I closed found out I do not have a Fannie Mae loan. I filed aa lawsuit and BOA quit taking my payments at the bank trying to foreclosure so I have to pay my attorney the payments to send to BOA I learned that Banks not only sell the foreclosed houses for 50% of value, but they also file a Title Insurance Claim that the homeowner paid for and Lender receives a check for the loan balance. That is a big incentive.
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