Around the Horn: Bernanke on Principal Writedowns. Appraisal Code-of-Conduct Coming Soon

by Alex Stenback on March 4, 2008

A couple of interesting developments in the mortgage world that are worth pointing out:

Bernanke: Lenders Should Be Writing Down Principal on Troubled Loans
Speaking at the Independent Community Bankers Conference [full text of remarks]:

  • "In this environment, principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure. "
  • …a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure. "
  • A writedown that is sufficient to make borrowers eligible for a new loan would remove the downside risk to investors of additional writedowns or a re-default.

This idea has always made a great deal of sense, in our view, and is nothing more than a simple math problem – if the costs of a principal writedown are less than the projected loss in a foreclosure, write the thing down already.  The trick is here is separating the truly troubled borrower from the opportunist.

Another thorny issue: The idea that a loan reduction large enough to make the borrower eligible for a new loan (so they can refinance elsewhere, limiting the risk of additional writedowns or delinquency) might be easier said than done. These will be ‘troubled’ borrowers (we presume – these writedowns should not come free of a credit score penalty) with few refinancing options even after principal reduction.  If the decision is made to write down principal, best write it down to the point where default risk is limited, and assume there won’t be a lender willing to step in.

Fannie Mae/Freddie Mac Agree to Tighter Appraisal Controls.
A "code-of conduct" greement with NY AG Cuomo attempts to rein-in inflated appraisals by banks and brokers, some highlights from the WSJ:

  • The code bars lenders and their representatives from pressuring appraisers to supply inflated estimates of property values.
  • Bank employees who are involved in making loans won’t be allowed to choose appraisers.
  • Lenders won’t be able to make loans on the basis of appraisals from their own employees or from other companies they control.
  • The code also bars lenders from using appraisals ordered by mortgage brokers.
  • The new code does not take effect until next Jan 1st (2008)

This will blow up the business models of more than a few brokers, lenders, and appraisers who’ve been reliant on juiced values (providing, or receiving) to do business.  This will also end the tidy little revenue stream provided by bank/lender owned appraisal affiliates.  About time appraiser independence got some support.

{ 14 comments… read them below or add one }

MT March 4, 2008 at 2:15 pm

What about write downs for everyone else who have suffered equity loss but are not in danger of defaulting?? While I agree the carnage is not desirable overall, for those of us who haven’t gotten over our head and are now patiently waiting, cash in hand, for investment opportunities, its frustrating to see these bailout proposals floated. To quote one of the greatest all time movies, Airplane, “They knew what they were getting into when they bought their tickets. I say let ‘em crash.”

Alex/Editor March 4, 2008 at 2:38 pm

I totally understand the moral hazard/outrage here, but here’s the thing: this is about banks limiting losses – nothing more, nothing less – you almost have to divorce the borrower from the situation entirely to get at why this makes sense for servicers.

In those cases where the loan is going to default anyway (again, the trick is going to be in separating the true ‘doomed’ borrowers from opportunists who purposely miss a few payments in pursuit of a modification – this can be done) in many cases reducing principal will be a cheaper alternative than proceeding with a full foreclosure.

but whether it is a foreclosure or principal reduction, the servicers, lenders, and bond holders are going to lose money in the deal. This is a fact.

You don’t want to pay for this, understandably, but you will, through higher rates, down payment requirements, and tougher underwriting standards in the future. That is just an unpleasant reality of the current situation.

So here’s the point. As this crisis unfolds, however, whenever, and wherever lenders lose money, it will impact the non-defaulted/troubled/stupid borrower (read, you and me) in a manner more or less directly tied to the severity of the losses. In that sense, limiting the losses of lenders et al, as tough a pill as that can be to swallow, is something one should get behind. If you value relatively easy and affordable access to mortgage money, that is.

As comforting as it is to say “let em hang, damn the expense, they had it coming” the practical reality of the costs of that statement will hit you right in the pocketbook the next time you need a mortgage.

Nate March 4, 2008 at 5:49 pm

I understand why this could be beneficial to the banks from a cost/benefit analysis. As you mention the real problem with this is how you implement it fairly across all the borrowers.

Who is going to make these decisions at the banks? It’s taking them months to get back to offers on short sales, so how are the going to handle the flood of requests this would cause, and be able to actually investigate every case in enough detail to avoid fraud? I don’t see how the banks can write the rules and then find, hire and train the people to be able to implement this in enough time to have an impact.

And once you are offering reductions to the people who can’t afford their mortgages how do you prevent the people who can afford their mortgages from demanding the same treatment or mailing in their keys? It saves banks money on the mortgages that are currently going into foreclosure, but if it enrages the 90% of customers paying their mortgages other costs could be introduced.

Last, how do you revalue properties in the declining market? Who makes these decisions and based on what? If it’s the ability for the buyer to actually pay the loan back, you only reward people who over leveraged themselves in the first place. If it’s based on property values in a market, how do you choose the mark as the market declines? Forgive everyone X% now and another X% next year when the market declines further? Banks and the market have been incredibly reluctant to reprice home values so far, how can we do it so quickly and comprehensively?

The idea is valid, and looks great on paper, but actually implementing it seems incredibly difficult. I’d be surprised if banks are up to the task based on how they’ve handled problems so far.

Nate March 4, 2008 at 6:32 pm

I want to illustrate my concerns with this plan using an example.

Let’s say 2 couples both bought identical 300k condos in California at the height of the housing market, using no money down. Let’s also assume these condos are now worth 150K.

Couple A, makes 40K a year, they used a low teaser rate to buy. This is about to reset pushing them into foreclosure. The bank could forgive their debt, set their mortgage to fair market value of 150k, which they can possibly afford, and save X dollars instead of foreclosing.

Couple B, makes 100k a year, both make 50k, they used a non-adjustable rate mortgage, so their mortgage will not increase. They can afford their condo, even though they are horribly under water. If you reset their neighbors, what stops couple B from having 1 of them stop work or quit their job. Now they only make 50K, and would be headed for foreclosure, so they have the bank reset their mortgage to 150k as well. Doing this would result in a 3X improvement over that persons gross wages for a year, closer to 5X after taxes. This gives the average person more than enough incentive to do this. And it would be almost impossible to prevent or detect, because losing your job is a normal event that leads to foreclosure, it looks no different than other distress situations. How can you prove they lost it on purpose?

If the banks try to save money on the smaller percentage of people currently having problems, they will introduce massive losses in what other people currently making their payment can and will do. For every couple A there is at least 1 or more couple Bs. Giving all those couple Bs incentive to stick the banks with their losses is a horrible idea.

MT March 4, 2008 at 8:15 pm

Alex: I appreciate the follow up and the opportunity to debate this. I’m with Nate. I understand that “higher rates, down payment requirements, and tougher underwriting standards” are a by product of this mess. That is simply the pendulum swinging as far from the lack of those 3 items before. That I can handle and accept. The purported gov’t solution I can’t accept. It is bailing out the banks that don’t deserve bailout. It is bailing out consumers that don’t deserve bailout. It is penalizing those that aren’t in need of a bailout. Not all banks will fail, and not all consumers will go into foreclosure. Those that are left standing can do as they see fit.

Alex/Editor March 5, 2008 at 8:37 am

MT: The thing is, within the context of this debate here, nobody is talking about a bailout (though there has been some discussion about future equity sharing or vouchers, and some sort of govt involvement there by buying out these loans – an idea which I am dead against, by the way) these are private business making business decisions. It is literally as simple as “Which will cost less?”

And ‘deserve’ is a tricky term to insert into this debate. Does anyone deserve to have their debts wiped in Bankruptcy? Any business? They ran up the bills, after all. Since they shut down debtors prisons, there does have to be a legal mechanism to deal with such events.

Though Nate lays out an interesting argument for how principal writedown might cost the banks more, I am not convinced.

Couple B already has a HUGE incentive to walk away, before any bank even floats the idea of principal reduction.

In the scenario he decribes, couple B could just as easily go out, buy another home at market value, and mail the keys on the original (upside down property) back to the bank. The incentives and payoffs for the couple are the same, yet nobody has to quit their job. I actually think people would be more likely to try this scenario, than quitting a job in order to force a principal writedown that may be refused – at the very least the banks will want proof that they were fired, not just quit.

Again, we are back to, what will cost less. And I agree that whichever route is taken, the lenders/servicers are largely overmatched and lack the capacity to handle ANY of this in anything resembling an orderly, fair, or 100% just manner.

Nate March 5, 2008 at 10:01 am

I don’t think most people are walking away, or making such ruthless decisions yet. Others have reported on the trend, but no-one has found much evidence of it occurring in great numbers.

Where this gets interesting is how assumptions around credit ratings work. Traditionally people with higher credit ratings have tended to make “responsible” decisions about their credit, meaning that if they get themselves in trouble they work their way out of it and pay off their debts. People with lower credit ratings tend to be more “irresponsible” from a lenders perspective. People with higher credit get rewarded for their behavior with better interest rates and availability to lending.

Now, in an effort to save money in the short term, banks are inventing new programs to bail out people who are upside down in their homes. It may be through short sales, or like this new plan to forgive debt. These will naturally be viewed as a reward by other people, which is why you see such anger from these proposals. Currently, a most of these programs are being targeted primarily at people with lower credit, those who made “irresponsible” decisions to purchase a home they could not afford. This changes the rules of the game. Banks are now rewarding those who made the most irresponsible credit decisions. When you change the rules of a game, the participants tend to change how they play. In this case all of the people, who overpaid for homes they can afford, may reevaluate their decisions.

Currently I don’t know anyone entering foreclosure, but I have a number of friends and family who are now in tough spots because of decisions they made to purchase homes. None of these people are planning to mail the keys back, and I’ve mentioned the “you walk away” program. Instead they are doing what banks expect, and trying to work their way out of the debt. They are pushing back retirement, changing plans about when to have children, and saving less for retirement. This is the behavior Paulson called out in his speech “Today, 93 percent of American homeowners – 51 million households – pay their mortgages on time. Many are on tight budgets, sacrificing other things in order to make that payment. Only 2 percent are in foreclosure.” They are behaving this way because they have been conditioned to do so, not out of charitable feelings towards their banking institutions.

So my concern is that in order to save money in the short term, Banks are being too eager to “reward” the small percentage (large in real terms) of people currently in trouble. In doing so, they run very real risks of changing how the other 90+% behave. Which can and will quickly turn this into a losing proposition for the banks. So long as an additional 5-10% of this group changes their behavior it would wipe out the savings made by banks. By the way, it’s this 90% group you hear complaining about this, voicing their concerns over the changing rules.

Alex/Editor March 5, 2008 at 10:42 am

Well, that’s the big bet the banks/lenders/servicers will make if they decide to mark down principal for otherwise doomed borrowers: Will this incent the other 93% that DO pay on time, make sacrifices, etc. etc. to stop doing that, and stick the banks with the bill? Maybe, maybe not. I don’t know whether you or I can predict that, since there are lots of people right now, who are incented to the tune of 100K+ to walk away, yet don’t, even though it is clearly in their best financial interest to do so. As you mention there is no evidence that large numbers of people are walking away.

In this context, I just don’t see how a principal write down is a dramatic game changing shift for these folks – the incentives remain roughly the same – the 93% can go buy something else NOW, mail in the keys, save a 100 grand and don’t have to resort to personal finance gymnastics or trickery (convince the lender they are doomed and deserve a principal reduction) to achieve the same, or arguably better result. You are saying they’ll quit a job and go delinquent on a mortgage to get a write down out of what? Anger and spite? I am not sure I am ready to make that leap. Also, don’t forget, that any sort of write down won’t be a credit neutral event – underwriters in the future will treat this in almost the same way, if not the identical way as a past foreclosure.

That same 93% may also complain just as loudly if the banks let the thing unwind in the most expensive possible way by staking out the principled high ground and we wind up with 50% down payment requirements, floating rates, and higher credit risk spreads. “I’ve never been late or defaulted, so why am I subject to these rules that were caused by people with bad credit?”

Again, from a philisophical standpoint, I am with you here, but from a practical standpoint, these banks will, and probably should, make the choice of least loss now – particularly if their solvency depends on it – over the idea that maybe they will create more ruthless borrowers in the future.

Nate March 5, 2008 at 10:46 am

Alex, I reread your response and I think I found the misunderstanding. You’re being a banker and thinking rationally about this.

From a bank’s perspective a person who owes 300k on a property worth 150k and goes into foreclosure is less desirable than reworking the same person into a new 150k loan. Done properly, you can save money that would have been spent in foreclosing and reselling the property, and at the end you still have a new 150k mortgage in place.

You are of course correct, but outside the industry it’s viewed quite differently.

The person, who is foreclosed on, LOSES their home. They may be forgiven their debt, much like a bankruptcy, but they have to move. Home ownership is the “brass ring” everyone has been struggling for. This is what everyone has been told is the reward for the sacrifices that come with owning a home. The purported benefits of home ownership are why everyone else is struggling and sacrificing to make their home payments on under water properties. Society at large is willing to accept that people, who made a mistake, will be forgiven debt but not that they get to keep their property as well.

Reworking the mortgage, allows the person to stay in the home. This can be cheaper for the bank and possibly better for the community as well. However, the other 90% struggling to make their payments see it as rewarding the wrong people, they are allowed to stay “home owners” with all the imagined benefits. Given all the advertising from the Realtors associations, home builders and mortgage lenders that has helped reinforce these beliefs and helped fuel this industry for the last decade, it’s unlikely we can change this overnight by arguing for compassion.

Alex/Editor March 5, 2008 at 1:37 pm

The ‘Brass Ring’ indeed.

This touches on a point that I have been meaning to bring up as we kick this can down the road.

Amidst all of this discussion about rational this, and rational that, it is easy to lose sight of the fact that when it comes to homes, people don’t act purely in their own economic interest. Self interest, yes, but this is rarely measured in pure economic terms.

The home has social cachet, emotional attachments, and all sorts of other intangibles that cause people to behave in ways you might not expect.

In part, lenders relied on this fact in opening up the flood of loose credit.

At the end of all of this, the banks will have effectively subsidized home ownership for many that don’t deserve it. They made a horrible bet – they get to eat what they’ve cooked – and the indigestion will be visited on their profits, shareholders, and future consumers (though not the executives of said banks, apparently.)

This is why a private sector solution, though it may be frustrating for some, is the best, as frustrating as it is to know that a bunch of people got to keep being homeowners (because the bank made a decision that it would be a cheaper route than foreclosure) who by all rights should be renters.

The minute the govt steps in to fund this ‘subsidy’, then I am on your side of the debate.

bruce March 5, 2008 at 8:06 pm

The reason’s for people entering into forcloser are vast. We look to the lenders as the culprits in many cases, but as an agent that works the REO and retail side of real estate I find that just as many are due to other factors. Divorce is a leading factor with forcloser, how will the Government bail these poor souls out. Job loss, or in the case of many people in the lending, real estate or trades have seen, lower income levels. Who or what program will we use to increase the income for these unfortunate many. It may only be a matter of time before we find out that our unemployment level is much higher than our current levels appear. What I am anticipating is that all of the so called, self-employed contractors will soon find that there is no new home construction this summer! What bail out plan will help all of these people?

John M March 15, 2008 at 6:28 pm

Nate and others-

I can understand your concern over people sabotaging their economic situation to get a reduction, but I think that is very unlikely to happen in the real world.

In your example, one of the spouses would quit a job that brings cash into the family’s coffers. In your example the spouse quits to get a $150K reduction and, assuming the process takes a year, the couple nets a $100K return.

The fallacy is that there are very few couples making $100K can afford a 50% reduction in real income to get $100K in phantom income that they may never realize. That plan also involves a lot of heartache and a a huge hit to their credit rating. I doubt a couple that can afford to make their payments is going to view this as an attractive option.

Also, this is not a “government bailout” this is a couple of government officials telling the mortgage servicers and investors to pull thir heads out of their collective chutes.

Chris Matthews April 3, 2008 at 7:45 pm

HVCC – Appraisal Fraud & The New Code – The NY Attorney General in his own words “BELIEVES” a private investigation of Fannie / Freddie has discovered wide spread inflated appraisal values. The source of the inflated values are corrupt appraisers and mortgage brokers. The last time I checked mortgage brokers don’t apply their signature as the primary or review appraiser. If the investigation found fraudulent appraisals why aren’t the offenders being prosecuted? If the investigation found bribery why aren’t the offenders being prosecuted? Isn’t the NY Attorney General responsible for prosecuting criminals. What every happened to the phrase “Innocent until proven guilty”. The new code will allow the so-called corrupt appraiser and so-called corrupt mortgage broker to continue doing “indirect” business. Sounds like the NY Attorney General is more interested in making a name for himself than carrying out the duties of his office “PROSECUTION”. With every new crisis in America why do our elected and appointed officials broad stoke us with new feel good laws. I for one say enforce existing law. If an industry has wide spread corruption what better way to rid the bad element than prosecution. The back room closed door process in which this agreement has been struck is further suspicious. Apply the smell test. STINKS!

Mike September 13, 2008 at 6:39 am

This is no different than the stock market. The lender thought of me as a stock. I under-permormed. What do you do when your stock goes bad? You sell! At some point many of us have jumped back into a stock when the price was right. Well, once a principal mod happens the price becomes right. There’s NO reason to put a family on the street to only take the same risk with a new family. Lower the principal and change the loan to a fixed and you avoid the cost of a FC.
Those of you feeling like your left holding the bag – you should be thanking God that you aren’t in this mess. You should be greatful you didn’t get Cancer and have to go out on dis-ability.
To the moron who compared this to a car depreciating – you’re a moron. Apple and Oranges.
If you want vacant homes on your block – auctions happening – and vandalism -then watch your home plummet even more. If I were the guy that didn’t need help I would hope the lenders would fix the troubled buyers quickly so that my home would stop dropping in value.
Stop being so selfish and start praying that this market at least levels out.
Greedy people ALWAYS get what they deserve!

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