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Will Principal Reduction Save Housing?

Posted by Larry Doyle on January 23, 2012 12:53 PM |

While Washington has thrown everything and the kitchen sink to support our banking system and our economy over the last few years, Washington has been unable to prop up our housing market.

What do many in Washington and elsewhere believe needs to be done on the housing front? 

One does not need to look too far or listen too hard to get the signals emanating from Washington in regard to support for a mortgage principal reduction plan. The recently released White Paper from the Federal Reserve makes the case for just such a plan via Freddie and Fannie.

While many in Washington and elsewhere may view a mortgage principal reduction plan as a panacea for our housing woes, I would lend caution that we should not be quite so hasty to adopt this approach. Why so? Assuming that policy makers can manage and manipulate markets is a dicey proposition. When venturing down roads that are not often if ever traveled, we better navigate very carefully for the unknown and unintended consequences may be worse than the status quo.

Don’t believe me, then let’s look to a former colleague of mine who just so happens to be one of the most highly respected housing and mortgage analysts on Wall Street. I am referring to Dale Westhoff of Credit Suisse and formerly of Bear Stearns. Dale is widely quoted in a recent Bloomberg report, Mortgage Principal Cuts Don’t Help Homeowners:

Reducing mortgage balances is a risky idea that hasn’t been shown to keep borrowers who owe more than their property’s worth in their homes, according to Credit Suisse Group AG. (CSGN)

Of the 11 million of “underwater” homeowners, about 6.5 million have never missed a payment and 2 million more are making on-time payments after a delinquency, said Dale Westhoff, the bank’s global head of structured products research. Widespread principal reductions may drive defaults “much, much higher” as borrowers seek the aid, he said.

“We’ve never done this before; we don’t know what the risk is,” Westhoff, a top-ranked mortgage-bond analyst in polls by Institutional Investor magazine for 15 years in a row while at Bear Stearns Cos., said today at a briefing for reporters in New York. Along with creating so-called moral hazard, the step may also tighten lending by forcing banks to offer “price protection” to borrowers, he said.

Credit Suisse’s view puts it at odds with Federal Reserve Bank of New York President William C. Dudley; Amherst Securities Group LP analyst Laurie Goodman, a member of the Fixed Income Analysts Society’s Hall of Fame; and hedge-fund manager Greg Lippmann, who last year advocated principal reductions, citing data from his former employer, Deutsche Bank AG.

Dudley said this month policy makers should consider allowing non-delinquent borrowers to earn debt forgiveness with on-time payments, while state attorneys general and federal regulators may encourage principal reductions as part of a settlement being negotiated with the biggest banks over their foreclosure practices.

Data Credit Suisse examined show essentially no difference in re-default rates among delinquent borrowers given only payment reductions and those also offered smaller mortgages, Chandrajit Bhattacharya, an analyst at the bank, said at the briefing.

Based on loans in mortgage bonds without government backing, about 40 percent of borrowers whose payments were cut between 20 percent and 40 percent defaulted again after 12 months, regardless of whether they were more than 60 percent underwater or had home equity between zero and 20 percent, according to Credit Suisse.

Data from bank regulators also show almost no difference in re-defaults among loans in the portfolios of banks, whose modifications include principal cuts 18 percent of the time, and mortgages guaranteed by government-supported Fannie Mae and Freddie Mac, which don’t lower balances, Bhattacharya said.

“You’ve got to base policy on something that’s factual,” he said. “You can’t base policy on something that you expect that hasn’t happened yet.”

Basing policy upon factual analysis? What a novel concept.

While we do not and cannot categorically state what might happen under a mortgage principal reduction plan, we do know that this is another form of socializing private debts. That reality may provide a short term boost to the economy (which those looking to be reelected may appreciate), but it also comes with very real yet unknown long term costs.

This is all part and parcel of the Uncle Sam Economy in which we live.

Navigate accordingly.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets, our economy, and our political realm so that meaningful investor confidence and investor protection can be achieved.


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