Principle Reductions Grow

There were several interesting insights published in last week’s report from the Office of the Comptroller of the Currency. In particular, the share of loan modifications that incorporate principle reduction has grown steadily over the last year.

Typically an investor, bank or agency will choose a combination of changes to a loan in an attempt to ease the burden on the homeowner and improve the likelihood of payment. Those changes include, in order, capitalizing late fees or charges into the principle, a reduction in the mortgage rate, a rate freeze, a term extension, deferring the principle, and lastly a reduction of principle. In the 4th quarter of 2011, 94.5% of modifications were some combination of these options.

Of note is the recent increase in the share of loans that include a reduction in principle, 9.0% of modifications in the 4th quarter of 2011, up from 2.9% in the 4th quarter of 2010. Also on the rise were principle deferrals, which jumped from 9.5% to 25.9% over this same period and rate freezes which rose from 2.4% to 6.7%. Capitalizations dipped in the 3rd quarter of 2011, but were back in line with recent history in the 4th quarter, while term extensions fell for the 3rd consecutive quarter of 2011 and from a year earlier.

The expansion of interest in principle deferral and principle reduction at a time when short sales have risen steadily suggests that holders of mortgage debt have become more aggressive in their attempts at foreclosure prevention. Forecasts for foreclosures in 2012 and 2013 have been high, which might explain the increase in interest in the more extreme options. However, bottoming prices and declining re-default rates might also explain the increase in principle reductions, both of which increase the likelihood of payment for a modified mortgage.

Also of interest in the report are the means in which different entities choose to modify loans. Fannie Mae, Freddie Mac, and the FHA have offered few if any principle reductions, favoring capitalization, term extensions, rate reductions, and to a small extent principle deferrals. The FHA has exhibited a similar pattern, but very few principle deferrals. However, banks (portfolio) and private investors have favored rate reductions, principle reductions and principle deferrals to a greater extent than the FHA and GSEs. The difference in appetite for term extensions between investors and banks might reflect difficulty in pooling loans with non-standard maturities.

The variance between modification patterns of the GSEs and banks and investors is important. Both entities have a fiduciary duty to maximize profits for their investors whether they are the general tax paying public or private investors. Furthermore, both groups are potentially exposed to moral hazard on the part of borrowers who might decide to stop paying their mortgages in order to qualify for principle reductions if the institutions allow them. Consequently, the prevalence of principal deferral and reduction on the part of banks and investors relative to the GSEs is curious. One might argue that the GSEs have better quality loans than banks or investors; here too the OOC’s report provides insights. Since the GSEs and FHA offer virtually no principle reduction, the share of total loans with principle reductions in the report pertain to banks and private lenders. This group offered reductions to 7.0% of prime loans, 9.0% of ALT-A loans, and 12.8% of subprime. Clearly, quality has a role in driving principle reduction, but a significant number of prime borrowers are also receiving principle reductions from banks and investors.

The report made clear that modifications with a 20% reduction in the monthly payment, through one or more methods, had the lowest chance of re-defaulting. The share of loans with a modification where the monthly payment was reduced by 20% or more that were 60 days late six months after modification fell to 9.8% in the 4th quarter of 2011. In short, it appears that the aggressive approach has the strongest impact.

As labor market conditions improve, the trend toward principle reductions is likely to continue as the risk of unemployment weakens as a driver of default. Furthermore, given the private sector’s shift toward principle reduction and the more generous compensation for principle reductions in the revised HAMP plan, perhaps the GSEs should reconsider their stance on principle reductions, a move favored by both the Fed and the OCC.