Principal Reduction: Who Deserves It?

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Tuesday's hearing by the House Committee on Financial Services was ostensibly on "Second Liens and Other Barriers to Principal Reduction as an Effective Foreclosure Mitigation Program," as the mouthful of a title indicates. Many housing experts and regulators have come believe that principal reduction is the most effective way to stave off foreclosures. But amid the finger-pointing, denials and fact-finding, an interesting question emerged: Who, exactly, deserves a principal reduction?

It's a loaded question, fraught with politics, profits and notions of personal responsibility. But the fortunes of many struggling homeowners -- not to mention the government's foreclosure mitigation efforts -- might rest on the answer.At the hearing, bank executives suggested they have very different views on the subject, from outright opposition (JPMorgan Chase) to grudging acceptance (Bank of America). All of the banks opposed what they called "blanket" principal reductions.

Bank of America Home Loans President Barbara Desoer pointed to an "equitable" solution for first and second lienholders as the key to lifting the barrier to principal reduction. Right now, she said, the bank is modifying first liens without considering the second lien, if the second lien is held by another bank. House members commended Bank of America on its new "earned principal forgiveness," which enables underwater borrowers to earn principal forgiveness provided they make on-time payments.

Second liens -- typically a home equity line of credit or loan -- have been a big obstacle to mortgage modifications. Because second liens are junior to primary mortgage loans, their holders often are forced to take a big loss or be wiped out altogether when the principal owed on a first mortgage is reduced or a house gets foreclosed upon.

The four biggest US banks -- Bank of America, Chase, Citi and Wells Fargo -- hold about 42 percent of the $1.1 trillion in second-home liens. The banks indicated that more than 95 percent of their second lien customers were paying on time, and they did not believe there was a major problem with second lien defaults.

In other words, if these loans are performing, why risk wiping them out?

Chase indicated that of its $131 billion in home equity loans and lines, only 5 percent are 30 days or more delinquent, even though 50 percent of the total Chase second lien portfolio is underwater. So for Chase, this is not yet an emergency. Chase did indicate that when a loan is 150 days delinquent, it writes the loan down to current fair market value.

Another interesting fact from Chase: "almost 64 percent of borrowers who are 30 to 39 days delinquent on a first lien serviced by Chase are current on their second lien."

So it appears that, like credit cards, people pay their second liens before their first liens so they can continue to have access to their credit lines. Why should Chase fix a problem on second liens if they don't think the problem exists -- at least at this time?

They may change their tune as first liens are foreclosed and they lose the full value of the second if the house is underwater.

What's more, some believe that home equity loans and second liens may be the next shoe to drop. Late payments on home-equity loans hit record highs in the last quarter of 2009, according to the American Bankers Association, and research firm CreditSights, Inc. recently warned that the big banks could face some $30 billion in losses on these loans.

Clearly Chase is getting ready for that inevitable loss. On Wednesday, when JPMorgan Chase reported first quarter profits of $3.3 billion, it also indicated a set-aside of $3.7 billion to cover potential losses in its mortgage and home equity loan portfolios.

While even JPMorgan Chase admits that in some very specific cases principal forgiveness may be appropriate, the big question throughout the hearings was who deserves principal forgiveness. Each bank has its own set of criteria. Let's take a look:

JPMorgan Chase

David Lowman, Chief Executive Officer, JPMorgan Chase Home Lending, spoke in strong opposition to broad-based principal reduction, he did point to three segments of borrowers that might be eligible for principal reduction:
  1. Option ARM borrowers with very low payments who may need principal reduction to achieve an affordable and sustainable monthly payment. (Chase is designing a program for this segment of borrowers.)
  2. Current borrowers who want to apply for the new FHA program that include principal write-downs to fit within FHA's loan-to-value or debt-to-income parameters.
  3. Delinquent borrowers who qualify for FHA Hope for Homeowner loans and who need a principal reduction or possible total extinguishment of their second lien.
He indicated that Chase is now doing targeted testing for other high-risk borrowers to see if principal reduction is more effective.

Wells Fargo

Michael Heid, co-president of Wells Fargo Home Mortgage, pointed to the fact that "91% of Wells Fargo's first- and second-mortgage customers were current" and that just 3 percent of home equity line customers were two or more payments past due. Yet even with these statistics, Wells Fargo completed 50,000 home modifications that include principal reduction in 2009. Wells Fargo has reduced of total of $2.6 billion in principal. He added that, "On average, customers received a 15 percent reduction in principal amounting to greater than $50,000, and when combined with rate reductions and term extensions their average monthly payments dropped by 25 percent under the terms of their loan modification agreements."

Heid explained that "principal forgiveness is not an across-the-board solution." Not ever homeowner underwater falls behind on their mortgage. The key to a solution for each home owner is "payment affordability." He added that "Most homeowners in America are still very focused on doing what is necessary to stay current on their payment obligations and, in so doing, protecting their credit standing. For this reason, principal forgiveness needs to be used in a very careful manner."

The bank considers principal forgiveness when:
  • The home is owner-occupied and concentrated in areas with severe price declines, where there is little prospect for full recovery of home values.
  • The homeowner suffered financial hardships, but has sufficient, verifiable income to sustain homeownership as long as payments are appropriately reduced.
  • The homeowner wants to remain in his or her home.

CitiMortgage

Sanjiv Das, president and CEO of CitiMortgage, testified that Citi Mortgage has "used, and continues to use, principal reductions." He gave no numbers as to how many principal reductions have been used by Citi, nor did he supply any figures for total dollars reduced. He said, "We believe principal reductions are one of many options that must be used responsibly." And he added, "We believe principal reduction is not the only solution for those experiencing financial hardship."

So, essentially, he gave no clues to Citi's rules or thinking about principal reduction. Yet he did point to Citi's success in avoiding foreclosures. He said that in the fourth quarter of 2009 "we were able to help families in their efforts to avoid foreclosure by a ratio of 15 to 1." Since 2007, he said, Citi has helped 825,000 families avoid foreclosure.

Bank of America

As mentioned above, Barbara Desoer spoke about Bank of America's new "earned principal reduction" and received kudos for the program from the House committee. She indicated that 14 million first- and second-mortgage loans were managed by Bank of America and 1.4 million first-mortgage customers were late by 60 days or more. In addition to talking about the bank's foreclosure prevention efforts, she called for a change to allow mortgage terms to be extended up to 40 years.

She indicated that 86 percent of customers are current and pay their mortgages every month, "some of them making difficult choices and sacrifices to do so." Of the 2.2 million second liens that the bank holds, only about 4 percent are delinquent. She said Bank of America has taken "significant write-downs of $10.5 billion over the last two years on its home equity portfolio." Again, as we've seen with other banks, a greater percentage of first liens are underwater than second liens.

So, as you can see from these numbers, there is not a lot of incentive for the banks to agree to a principal write-down on second liens, such as equity lines, especially if most customers are paying them on time. That might change if the predictions of a home equity bust come to pass.

Lita Epstein has written more than 25 books including The 250 Questions You Should Ask About Buying Foreclosures and The Complete Idiot's Guide to Personal Bankruptcy.
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