Housing

Principal Forgiveness: Not a Complicated Matter

I’m looking at loan modification papers for homeowners who recently came to ESOP for help on their delinquent mortgage.  I’m struggling to understand what I’m looking at because it seems […]

I’m looking at loan modification papers for homeowners who recently came to ESOP for help on their delinquent mortgage.  I’m struggling to understand what I’m looking at because it seems to be a mistake.  It must be a mistake.  A home on the Westside of Cleveland, Ohio, with an outstanding mortgage balance of $174,400 has been reduced to $54,650. That’s $119,750 of principal reduction, 68 percent of the loan amount.

This is one of those SAM (Shared Appreciation Modification) workouts that Ocwen Financial has spent the last year touting inside and outside the Beltway. Ocwen is a subprime servicer with years of hard-knock experience dealing with the back end of the subprime mess and they're on to something our friends at FHFA seem not to understand, but more on that later.

Looking at the underlying numbers, the thinking behind the modification becomes clear.  The Marshalls bought their house in this neighborhood of tidy bungalows at the top of the market in 2006, with a subprime loan.  They hit a dry patch just as home values began to tank.

So they bought high, fell delinquent low, and what with penalties and fees, court costs, lawyers, and etc. the outstanding balance jumped to nearly $175,000. Under the Ocwen SAM, the Marshalls have to make three years of payments at the reduced interest rate on the reduced balance and each year 1/3rd of the $119,750 is deducted.  The upside for Ocwen’s investors is that they stand to get back 25 percent of any increase in value over $54,650 when the property is sold or refied.
This deal goes against what we have been told: that principal “forgiveness” won’t work, can’t work, and shouldn’t work, (because it’s bad for our morals).  Many of the arguments against adjusting the mortgage balance to match a collapsed home’s value are simply myths. Falsehoods, so often repeated, they become industry, and then, cultural memes. 

For example, how often have we been told that private label pooling and servicing agreements (PSAs) won’t permit servicers to make principal reductions, because modification options are so limited and locked down by contract language.  Not so, says Ocwen.  Read most PSAs carefully and the “prime directive” for the servicer is always the same: maximize cash flow and investor returns.  Not very complicated.  Actual fact: common sense and the duty to act in the client’s best interest is not usually prohibited by contract.

Here’s another legend:  Net present value calculations “are what they are”.  We are assured that NPV analysis is mathematically rigorous—-you can’t negotiate with numbers.  In fact, there are numerous input/variables for NPV calculations that are supposed to predict the value of future cash flows.  Not what the values are today, what they will be over the potential 30 to 40 year term of a modified mortgage.  (Care to venture a guess on what capital returns will be in 2053? Uh huh, sure.)  As a rule, two major NPV inputs have not been shared by servicers with borrowers.  The discount rate for future cash flows and the servicer’s estimated current value of their home.  There’s a lot of wiggle room here people, no one should be surprised that honest men can disagree about that-which-has-not- happened-yet. . . but might, in 40 years.

Truth is, net present value calculations are what we chose them to be, not “what they are.”

Rest assured Ocwen cleared this deal with their investor-clients.  Ocwen’s NPV inputs (whatever they were) simply persuaded investors that deep cuts now, will yield better returns later.  Investors will certainly lose money, but they will lose more money taking the home back. Not very complicated.

Then there is the Most Pious and Holy Meme of them all. Moral hazard will create “false” loan defaults by homeowners who see an opportunity to game the system.  Horrors!  What will we do?  What ever will we do?

Ever seen what happens to a credit score when a borrower falls 60 days behind on their mortgage?  Very ugly, and very costly to any American consumer. 

But let’s say a desperate homeowner will trade in their credit standing for a chance to bail or to get new and better price for their home.  (Yes, we know, it will happen.) But are we supposed to believe that a contrived delinquency cannot be discerned from reviewing the documentation required for loan workouts?  How many software products are peddled to loan originators, all promising to expose fraud or suspicious activity in a loan application?  And what is a loan workout but an application for a re-originated loan?

OK, but what about the moral hazard here, in the Marshall workout?  We asked the ESOP staffer who worked with the Marshalls.  “Well to tell the truth, it never came up.”  Not very complicated.

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