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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.


  • coe

    There is no doubt in my mind that there are legions of unsophisticated victims of predatory lending practices – in both mortgage and in credit card land…I happen to have learned this first hand – the case study belongs to my mom!

    Here was an 84 yr old simple housewife being led down the primrose path of a pick-a-pay cash out refi by a broker – World Savings to Wachovia to Wells – the three wise “w”‘s in this all too real nightmare…my mom’s impeccable credit FICO history “qualified” her for a much needed cash infusion – oh, but guess what – the broker used a highly inflated “retirement income” number (6x the real number) to make the ratios work (yes, sadly – my mom signed the application – but she has never lied in her life – so to turn a $900 social security check into a $6000monthly infusion is preposterous- and he, the broker, took out a 8K fee on a $100K loan…and yes, the coupon offers my mom the option to pay in relative terms $1, $2 or $5 – guess what number my mom picked (btw, there is no small print or anything I can find in the coupon voucher that speaks to negative am!) –

    what a totally appropriate instrument for an 84yr old widow with very limited fixed income, eh! roll the calendar forward three years and the loan balance has increased some $35K on the original balance, property values are down 21% in the MSA, and mom, to avoid embarrassment, takes out cash from 18 different credit cards to try to swim against the tide – how is this possible you ask? because the cc cos all foamed at the mouth to give this 84yr old woman credit and then blast her with late fees and near usurious interest rate expense…

    upon finally learning of this debacle, I have so far unsuccessfully tried to navigate the cc negotiation process and deal with the numbskulls at Wells Mortgage – who didn’t even know that a class action lawsuit was settled on behalf of “victims” of the insidious “pick-a-pay” mortgage…my mom’s share of the settlement – a whopping $170 – that’s right – $170 – no good deed goes unpunished…

    I’m ready to escalate this story to the national media and the CEO offices of Wells and the various cc cos – and trust me, if this fuse gets lit, there will be blood!…

    how this relates to the modification story is that Wells determined that my mom could not afford a modified lower payment but nonetheless asserted that the original terms of the pick-a-pay mortgage should stay in place – huh! you cannot pay a lower amount, so let’s let you continue to pay a larger amount and accrue additional capitalized interest additions to the outstanding principal amount – what a solution…

    having just seen the electrifying earnings of Wells recent release – mostly attributed to their mortgage business – I can tell you that the company is a blood-sucking vampire – regardless of any image spin that Stumpf may put on such disgraceful behavior – there is NO ethical honor in the banking system…

    we need to jump start the housing sector – it will take a real effort to address legacy issues – like my mother’s case, and to reengineer a more vanilla workable model for new business…I would put the broker, the bank executives, the credit card executives – the whole lot of them in jail for violation of the “suitability” groundrule and do it in the public square…

    one poor woman/one real story of hardship – a long queue of really evil businessmen…this country needs help…the mortgage policy debate needs leadership…and it’s like screaming into the vapors…will somebody out there inject some reason into the equation…

    take up the cry, LD!

    • LD


      Let’s work on drafting a well detailed and hard hitting commentary that lays out the gory story you highlight here.

      We will be providing a wealth of ‘sense on cents’ in the process.

      Dear Mom deserves nothing less.

    • Always Learning

      coe –

      Your vivid description of your mother’s situation is heartbreaking. The fear and panic she must have felt upon realizing she would have to tap into credit card advances to stay afloat! It is vile that anyone would take such advantage of a senior citizen. I’m sickened by this.

  • AWAM

    Please write something about the implications of all forms of Residential Mortage loss mitigation strategies on taxes and reserves for banks where mortgages are held for investment. Which strategy has the least impact on the bank/servicer financially in the short and long term? Which has the most? The method with the least impact is/will be the method of choice, but I have never seen anyone anywhere talk about the tax and financial aspects. At the same time most of us know that if you just follow the money, all will be revealed.

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