Banks Forgiving Mortgage Principle: Reward for Bad Behavior?

In a rather disturbing trend, some banks are beginning to forgive portions of the principle owed on mortgages in arrears:

(From the WSJ):   "As home prices slide and loan defaults pile up, some mortgage companies are slashing the amount that borrowers owe, deciding that a permanent cut in the loan balance may pay off if that helps teetering borrowers avoid foreclosure.

The small but growing push sharply contrasts with most loan-modification programs. Borrowers often get a lower interest rate or years longer to pay off their mortgage. But such changes may not be enough to make the loan payment affordable and don't fix the problem of borrowers owing more than their home is worth.

Reducing the principal on mortgages is "a last resort," says Paul Koches, executive vice president at Ocwen Financial Corp., a West Palm Beach, Fla., loan servicer that has shrunk the amount owed on 10,884 delinquent mortgages as of Sept. 30. That is 23% of all the loans modified by Ocwen so far this year.

On average, such borrowers saw their loan payments drop by 20% to 40%, typically by lowering the loan balance and interest rate. Ocwen estimates that the savings for investors who own the mortgages vary from a nominal amount to more than $325,000 per loan compared with the likely return if the loans wound up in foreclosure.

Many mortgage lenders and servicers have been reluctant to drastically change loan terms, in part because of worries that would antagonize investors who own securities tied to the loans. Mortgage servicers are responsible for collecting mortgage payments and working with troubled borrowers.

Not everyone agrees reducing the loan balance is the right move. J.P. Morgan Chase & Co.'s new effort to restructure as much as $70 billion in mortgage loans doesn't include principal write-downs. Instead, J.P. Morgan will sometimes base new loan payments on a smaller loan balance, while requiring that the full loan amount be repaid when the borrower refinances or sells the home. This approach lets the bank benefit from any subsequent increase in home values, a spokesman says.

But as foreclosures mount and the economy worsens, there is "a begrudging acceptance...that this is the way things have to move," says Sharon Greenberg, a mortgage strategist with Barclays Capital, a unit of Barclays PLC."

Graphic courtesy of the WSJ

In other words we're heading towards a situation where it's likely that a large number of borrowers are going to have their debt forgiven en masse, and it's probably only a matter of time before previously rejected proposals to begin forgiving credit card debt catch hold.

All of this begs the question: if we have a crisis that was caused by irresponsibility on the part of both borrowers, regulators and lenders, what happens when you start effectively rewarding many of these same people for their misdeeds and punishing those who behaved responsibly?

I understand that in extreme times extreme measures are needed, but I just can't support anything that rewards the irresponsible and doesn't punish those who need to be bailed out.

In any case, if idea of debt forgiveness continues to take hold don't be surprised if America's debt addiction subsides for only a short time period before it comes back stronger than ever.

Mind you I understand that debt forgiveness may very well turn into a necessary evil, but there should be some sort of penalty imposed on those who receive it, and/or the banks should only do it on the condition that they get a piece of the action if the value of the home recovers.

You can read more here.

Sources

The WSJ: "New Tact in Default Battle: Cutting Mortgage Principle" -- Ruth Simon, November 20, 2008.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.

Comments

[SW Richmond:]

When financial contracts are unenforceable, how can anyone "invest"? How can capital be put to work?

Put another way, if one wanted to drive the last nail in the coffin of capitalism, what could be more effective than to kill the basis of capitalism: enforcement of financial contracts? How can capital ever be applied anywhere if ownership is not protected by contract law?

How can there be winners if there are no losers? Why should smart and motivated people work hard and create? Why should I teach my kids to be hard working and honest, so that others can vote to steal from them?

Someone tell me please, because I really don't know anymore.

2008 Nov 21 10:43 AM

[waf76:]

i agree, if debt forgiveness is going to be the norm then why should i pay my mortgage and my credit cards? why should i invest in stocks or put money away through my 401k? Its absolutely ridiculous. Everyone made their own bed, now you have to lie in it. When I made a bad decision I wasn't bailed out. We're not all in this together.

2008 Nov 21 11:05 AM

[Karen Consumer:]

Yes it's ugly. But creditors knew this when they went to Congress in 03/04 and demanded that they re-work bankruptcy law making it more difficult for consumers to declare bankruptcy.

You can purposely work with the debtor and take 50% to 75% of what they can pay, or you can take nothing.

I'm a consumer. I CAN pay my house, I CANNOT pay my credit card. If I let my house go, it sits empty, gets stripped of copper, incurs liens from the city for failing to maintain it, maybe it even turns into a dope squat. If I let my credit card go, I have to save money to buy products.

The bank gets money if I stay in my house. The bank gets nothing if they don't know where I'm at.

You're the investor in the bank, you can get a percentage of something, or absolutely nothing. Forgiving SOME debt leaves a bad taste, but not as bad as getting nothing in return.

2008 Nov 21 02:54 PM

[CanadianInS...:]

In this context, the word you want to use is principal, not principle. Yet another demonstration of the weaknesses of spell checkers - correct spelling, wrong word.

2008 Nov 21 03:33 PM

[bs_o_meter:]

hmm.... maybe you are on the wrong website. we are not into spelling here.

2008 Nov 22 01:13 AM

[Bill Zielinski:]

I think it likely that the trend towards loan modifications will have unintended adverse consequences such as prolonging and increasing the value erosion of residential real estate. How often do big government sponsored programs work, especially when attempting to interrupt free market forces? The moral hazard is obvious and this program institutionalizes the repudiation of debt on a massive scale, thereby creating more losses for a broad spectrum of debt holders.
There is also a movement to change the bankruptcy laws and allow the courts to forgive mortgage debt. When you combine these factors, lending or investing in mortgages has become very high risk. To compensate properly for the higher risk, mortgage lending by private capital will either disappear or demand an appropriately high risk adjustment factored into the lending rate.

2008 Nov 22 03:57 PM

[BankerDustin:]

I cannot believe people are even thinking "principle forgiveness". This is one of the most idiotic ideas to ever be even brought up. I think I will take my car back and request some of what I owe be knocked off the loan because it went down in value as soon as I drove it off the lot. Sounds crazy huh? Then why are people bringing it up pertaiining to mortgages? These radio/TV commercials are hilarious. "Credit cards debt/late mortgage payments are not your fault" Bull. The truth is that people got mortgages they could not afford. The "big bad mortage company" did not force them to sign the dotted line. The mortgagors lived beyond their means. THEY racked up credit cards on things they could not afford (which I call legalized stealing, they have no intention of paying it back). These people dug their own holes, let them lay in them. Send them to foreclosure, take the loss, keep the property values down to where they should be and lets reboot with people that will actually pay their mortgages.

Aug 28 04:45 PM