Those Troublesome Option ARMs

The mortgage industry’s most difficult challenge in loan performance and loan modification comes from loans that do not amortize or may even negatively amortize. As progress is made in reducing overall exposure to these loans, the performance of surviving option ARMs continues to worsen and losses mount.

Mortgage Banking
May 2011

By Robert Stowe England

It would be no surprise to learn there is a recurring nightmare plaguing people in the mortgage servicing industry. In this bad dream, servicers become firefighters battling a forest fire that keeps burning up mortgaged homes without hazard insurance, leaving nothing but charred remains.

Every time the firefighters dampen or extinguish the flames in one area, fire breaks out and becomes even larger in another. The more they fight the fires, the more they spread, and the more homes are burned.

When the servicers wake up, they find something similar in the real world. Instead of fighting fires, they are fighting to contain the financial cost of foreclosures by salvaging as many of the most troublesome loans as possible.

One loan product in particular is the most troubling for servicers. And that is the payment option adjustable-rate mortgage (pay option ARM). These loans allow borrowers to make a minimum payment that can be even less than the interest due on the loan and, thus, add to the principal. Such loans are especially problematic because they can lead to negative amortization.

The size of the problem

According to Santa Ana, California-based CoreLogic, there were 781,580 option ARMs as of December 2010, with an active loan balance of $234.5 billion. The option ARMs are almost entirely portfolio loans while the non-amortizing interest only or IOs were mostly loans that went into mortgage-backed securities (MBS), both private-label, as well as Fannie Mae and Freddie Mac loans.

“People got aggressive with the option ARMs,” recalls Guy Cecala, president of Inside Mortgage Finance, Bethesda, Maryland. “World Savings [Bank] was offering them for 40 years,” he points out. “That was their ARM product.”

“Initially, it didn’t have a minimal payment,” he notes, in reference to one of the payment choices offered with the option ARM product. World Savings, however, would tell its customers, “‘Here’s the monthly payment, say $1,500. If you are going into an emergency, you can pay a smaller amount and catch up later,’” Cecala recalls.

“What happened in the early 2000s [is that] people started getting aggressive with [the loan product],” Cecala recalls. “WaMu [Washington Mutual], Countrywide [Home Loans] and World Savings got into a bidding thing,” he says. “They all started out with, ‘Here’s your minimum payment.’ Lo and behold, that’s all people started.” 

It’s not clear who started the bidding war on option ARMs, according to Cecala. “A case can be made it wasn’t World Savings originally” that started the bidding war in marketing option ARMs. “Countrywide points fingers at WaMu,” he adds.

“By far the top three lenders in option ARMs were World Savings [Golden West Financial], Countrywide and WaMu. Those are the biggest legacy portfolios out there. In their heyday, each one was over $100 billion,” Cecala says.

Lenders originated $255 billion in option ARMs in 2006 alone--a year that also saw the origination of $387 billion in interest only or IO ARMs, according to Inside Mortgage Finance.

On the positive side, the exposure to option ARMs has declined steadily. In December 2008, for example, there were 983,899 option ARMs with an active loan balance of $300.7 billion, according to CoreLogic.

The exposure to Option ARMs, thus, declined 22 percent from $300.6 billion to $234 billion in two years, from December 2008 to December 2010.

Aggressive loss mitigation

Option ARMs are concentrated in the hands of a few mortgage servicers, all of which acquired the loans through an acquisition of a major mortgage lender. Wells Fargo Home Loans, Des Moines, Iowa, acquired one of the largest portfolios of option ARMs in 2008 when it acquired Wachovia Bank, which in turn, obtained the portfolio when it took over Golden West in 2007.

Bank of America, Charlotte, North Carolina, acquired a big portfolio of option ARMs when it acquired Countrywide Home Loans in 2008. Finally, JPMorgan Chase & Co. New York acquired a large portfolio of option ARMs when it acquired Washington Mutual in 2008.

All three companies have been willing to engage in loan modifications of option ARMs that involve principal reduction or forgiveness.

The reduced overall exposure to these products currently is by design, according to Cecala. “I’m not aware of anyone who inherited option ARM portfolios in those three big lenders who hasn’t been very aggressive,” he says.

Not only has there been principal reduction at all three, “They’ve also been converting option ARMs to other loans. They’ve been refinancing people into 30-year fixed mortgages or regular ARMs,” Cecala says.

The problem for the mortgage industry, however, is that as fast as the number of these loans declines--either from foreclosures, refinancing or sales--the higher the delinquency, default and foreclosure rates go on the remaining loans.

Of all current active loans in December 2010, the number of option ARMs in foreclosure had reached 14.4 percent, according to CoreLogic. In December 2008, by comparison, foreclosures for option ARMs stood at 5.5 percent.

A losing battle?

However, when one looks at the approximate principal balance in foreclosure for option ARMS, the number is steadily rising. Thus, the harder the servicing industry tries, the farther it falls behind on--even though some individual companies are winning the battle.

When the principal balance on foreclosed homes with option ARMs was 6.7 percent in December 2008, it represented roughly $20.2 billion out of $300 billion in option ARMs outstanding.

However, by December 2010, the principal balance of foreclosed homes with option ARMs was 17.8 percent or $41.8 billion of $234.5 billion in principal balances for all option ARMs. Thus, loss exposure on foreclosed homes with option ARMs doubled in two years, from $20.2 billion to $41.8 billion.

These exposures included real estate-owned (REO) properties that had option ARMs. That represented $4.3 billion in December 2008 and $4.0 billion in December 2010.

Actual losses on option ARMs, of course, will be less than the $41.8 billion exposure in foreclosed and REO homes and will depend on the amount recovered from the sale of foreclosed homes.

Sky-high delinquencies

The trend in delinquencies for option ARMs is also troubling. The loss exposure on principal balances for option ARMs is continuing to rise.

In December 2010, the total principal balance of option ARMs delinquent by 90 or more days was a staggering 38.48 percent or $90 billion. This was sharply higher than the principal balance on delinquent loans two year earlier, when it stood at 17.99 percent or $54 billion.

The continuing problems with option ARMs contrast with an overall delinquency picture that is improving, while defaults are marginally higher.

The Mortgage Bankers Association’s (MBA’s) National Delinquency Survey reported that the seasonally adjusted delinquency rate for the fourth quarter of 2010 fell to 8.22 percent of all loans outstanding on one-to-four-family residential properties. This was a distinct 91 basis points lower than the prior quarter and a decline of 125 basis points from the fourth quarter of 2009, when delinquencies stood at 9.45 percent.

The combined percentage of loans in foreclosure or at least one payment past due was 13.56 percent on a non-seasonally adjusted basis, a 22 basis point decline from 13.78 percent last quarter.

“These latest delinquency numbers represent significant, across-the-board decreases in mortgage delinquency rates in the United States,” said MBA Chief Economist Jay Brinkmann. 

“Total delinquencies, which exclude loans in the process of foreclosure, are now at their lowest level since the end of 2008. Mortgages only one payment past due are now at the lowest level since the end of 2007--the very beginning of the recession,” he added. 

“Perhaps most importantly, loans three payments (90 days) or more past due have fallen from an all-time-high delinquency rate of 5.02 percent at the end of the first quarter of 2010 to 3.63 percent at the end of the fourth quarter of 2010--a drop of 139 basis points or almost 28 percent over the course of the year,” Brinkmann said. 

“While delinquency and foreclosure rates are still well above historical norms, we have clearly turned the corner,” Brinkmann said. “Absent a significant economic reversal, the delinquency picture should continue to improve during 2011.”     

Some encouraging signs

Other surveys of loan performance also found some encouraging improvements in the broader mortgage market. The Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS) jointly reported a generally improving loan performance picture for mortgages in their report for the fourth quarter of 2010, which was released March 31.

The OCC and OTS Mortgage Metrics Report covers 63 percent of all mortgages outstanding--32.9 million loans with principal balances of $5.7 trillion.

“While mortgage delinquency levels remained elevated, the overall quality of the portfolio of mortgages included in this report improved from the previous quarter,” the OCC and OTS reported. “The percentage of mortgages that were seriously delinquent declined for the fourth consecutive quarter to the lowest level since the second quarter of 2009,” according to the report.

The percentage of mortgages that were current and performing increased to 87.6 percent. This is the highest level since the second quarter of 2009.

The OCC and OTS found that government-guaranteed mortgages – backed by FHA and VA -- performed slightly worse than the overall portfolio; that is, 85 percent of these mortgages were current and performing.

Fannie Mae and Freddie Mac mortgages had a better-than-average performance--92.6 percent were current and performing. Conforming loans make up 61 percent of the portfolio monitored by the OCC and OTS.

The OCC/OTS report also found that the number of new Home Affordable Modification Program (HAMP) modifications had declined in the fourth quarter by 4 percent to 56,378 from 58,789 in the prior quarter and down from 95,249 in the fourth quarter of 2009.

The number of loan modifications overall, however, rose a modest 1 percent in the fourth quarter of 2010 to 473,415 from 468,499 in the prior quarter, but the level of loan-modification activity was down from 601,342 in the fourth quarter of 2009, based on the report.

The OCC/OTS report also found that nearly 90 percent of overall loan modifications in the fourth quarter reduced monthly payments, while more than 56 percent reduced the payment by 20 percent or more. The average reduction in monthly payment was $414 or 25.5 percent of the original payment.

While the bad news continues to be that modified loans re-default at very high rates, the rate of re-defaults is modestly declining. The OCC/OTS report found that 47.5 percent of loans modified in the third quarter of 2009 were in re-default 12 months later. By comparison, loans modified in the fourth quarter of 2009, the re-default rate was 44.7 percent a year later.

Similar improvements were seen three months after the loan modification. Of the loans modified in the second quarter of 2010, 23.5 percent were in re-default three months later. For the fourth quarter of 2009, the re-default rate was 20.7 percent three months later.

Wells Fargo Home Mortgage’s efforts

Wells Fargo has been perhaps the most aggressive in trying to stem the losses in its option ARM portfolio through targeted loan modifications, some of which involve principal reduction, according to Cecala. “[Major servicers] were all very circumspect about discussing it,” he adds, referring to Wells Fargo, JPMorgan Chase and Bank of America. “Nobody wanted to publicize they were offering principal write-downs.

“Lenders aren’t convinced write-downs are a good idea,” Cecala says. “They don’t want to be seen putting out a message that if you do certain things, you can qualify.”

However, there may be justifications for principal reduction with option ARMs, according to Cecala. “Option ARM borrowers are underwater due to features of loans. Others are underwater through bad financial decisions--putting no money down, stripping all the equity out of their houses through multiple cash-out refis,” he continues. “That really is the issue.”

Cecala says, “If you eliminated option ARMs borrowers, borrowers with no money down, borrowers who did cash-out refis to take out equity in good times, you don’t have a lot of underwater borrowers left who would qualify for principal write-down.” He adds, “That’s one of the big issues out there.

“Just like with the HAMP, the industry really wants to handle it on a case-by-case basis. The government, too. They want people who get relief to deserve the relief,” Cecala says.

For Wells Fargo, the option ARM loans it acquired with the acquisition of Wachovia were definitely not the type of loans the company would have made on its own, according to Teri Schrettenbrunner, senior vice president of communications for Wells Fargo Home Mortgage.

“Wells Fargo actually made the decision in the 2004 to 2006 time frame that it was not going to make option ARMs or negative amortizing loans,” says Schrettenbrunner. “We got into this business at the point [that] we merged with Wachovia on Dec. 31, 2008,” she adds.

Wachovia may have already discontinued making Pick-A-Pay mortgages at that point. Pick-A-Pay is the name Wachovia gave to its option ARMs.

“When we merged with Wachovia, we took a look and analyzed the portfolio of loans. We had not had any experience with that type of loan,” Schrettenbrunner says. It quickly became clear that the option ARMs posed a considerable challenge for Wells Fargo and the borrowers. Wells Fargo executives then asked, “’What would be the most successful outcome for that group of people?,’” Schrettenbrunner says. “At that point, we started our outreach immediately.”

Within two weeks of the merger, “We had a communication out to the Wachovia Pick-A-Pay customers to say, ‘OK, talk to us, let’s figure out what we can do here.’” Wells Fargo put together a number of “tools” to get people into affordable payments. These tools included interest-rate reduction, term extension on the mortgage, and principal forgiveness, according to Schrettenbrunner.

The Mortgage Assistance Program

“So we began that program, which we called the Mortgage Assistance Program, or MAP, for Wachovia Pick-A-Payment Customers,” Schrettenbrunner says. From January 2009 through the end of 2010, for the option ARM portfolio as well as some other loans, Wells Fargo has done $3.8 billion in principal forgiveness for 73,000 customers, she adds. “That’s about an average of $51,000 per loan,” she says.

Wells Fargo was willing to make offers to borrowers with option ARMs because they faced a different challenge than other borrowers. “The product features are unique,” Schrettenbrunner says, “so they required taking a unique look at it to get customers to the point of affordability”--that is, to a point where they could afford the monthly payments.

Wells Fargo began with the program of earned principal reduction in January 2009. Borrowers who were given this option had “to earn principal [forgiveness] down to the 115 percent [loan-to-value (LTV)] level,” Schrettenbrunner says. “So what happens is that if they make 12 consecutive on-time payments for the loan that we modified, we will give them one-third of that principal forgiveness,” she adds. “And then they make another 12 months, and we give them another third, and then they make another 12 months, and we give them another third.”

She adds, “So, it is three equal amounts spread over a three-year time period, as long as the customer remains in good standing. The concept is to encourage people to make their payments.”

In October 2010, Wells Fargo added another option. It would provide immediate principal forgiveness to get a loan down to 150 percent of market value. From that level, borrowers could earn additional principal forgiveness.

“We go through a waterfall of steps, and basically what happens is . . . if the customer has greater than 150 percent [LTV], we forgive down to the 150 percent level,” Schrettenbrunner says.

Wells Fargo is also offering borrowers a chance to participate in the HAMP Principal Reduction Alternative (PRA) program, which became available in October 2010. This program is available for portfolio and securitized loans, but only for private-label securitizations and not for Fannie Mae, Freddie Mac, Federal Housing Administration (FHA) or Ginnie Mae loans.

Initially, the reduction is a principal deferral or forbearance to the borrower sufficient to get the mortgage down to 115 percent of the value of the home. This means the principal, which does not earn interest after it is deferred, is tacked on at the end of the mortgage and extends the duration of the mortgage. However, the PRA’s forbearance of principal can convert to forgiveness of principal. On the first, second and third anniversaries of the borrower’s trial period effective date, one-third of the original principal reduction amount will be forgiven as long as the borrower remains in good standing, according to a summary of terms provided by HAMP.

Helpful factors

Investors in mortgage-backed securities are provided incentives to participate in the Principal Reduction Alternative program.

The fates have not been completely unkind to option ARM borrowers. Because most of the loans are tied to the London interbank offered rate (LIBOR), the interest rate that borrowers are paying is very low. “Across the board, interest-rate reductions have had a positive impact on a number of people who have had these loans,” Schrettenbrunner says.

“What has actually helped is that Golden West and other institutions . . . held these loans on their books. They didn’t sell them off into the securities market. So, they are not constrained by what investors say they can and cannot do,” Schrettenbrunner says.

Borrowers who participate in the program do not have to wait until a recast of an option ARM occurs, which is usually when negative amortization pushes up the principal balance to a level that is 110 percent or some designated LTV that requires the loan be recast. The loan typically then requires a principal and interest payment.

“The modification is driven by the timing of the customer’s hardship,” Schrettenbrunner says. “If the customer faced a hardship during whatever period of time they had this loan, whether or not it was at the initial rate or the bumped-up rate, then they had the opportunity at that point in time to work with us on a modification,” she explains.

“A modification is a re-look at the contract to say, ‘You can’t afford to make your payments at this level, so we are going to modify this loan to a level we agree is appropriate for you to be able to manage the payments going forward,’” Schrettenbrunner.

She adds, “So you may have a great job, everything is going OK, you don’t have anything hitting you, your loan recasts, you can make your payments, in which case you will not get a modification.

“But I may have a loan that I can’t afford to make the payments [on] anymore because it recast to a level that was higher than I am able to pay for at this point. I may be facing unemployment or underemployment as a result of what’s happening in the economy today. And I can’t make the new payment. I have to prove my hardship. I have to prove I can’t make this payment. And then I can work with the financial institution on a modification,” says Schrettenbrunner.

The loan is modified to get the mortgage debt-to-income ratio for the monthly payment to 31 percent, according to Schrettenbrunner.

Progress being made

Wells Fargo has made considerable progress in reducing its exposure to the $101.3 billion Wachovia portfolio of option ARMs, according to the credit supplement to fourth-quarter earnings report filed by Wells Fargo. Wachovia’s portfolio also had $16 billion in other ARMs and fixed-rate loans, for a total exposure of $117.3 billion. When Wells Fargo acquired these mortgages, it put them on the books at $95.3 billion.

By the end of 2010, $23.3 billion of the Wachovia mortgage portfolio had been modified, while $54 billion in Pick-A-Pay loans were still on the books. Exposure to other ARMs and fixed-rate loans from Wachovia was reduced to $12.3 billion. Thus, the Wachovia portfolio exposure was reduced to $89.6 billion, which Wells Fargo is carrying at a value of $75.8 billion.

Wells Fargo, thus, has reduced its exposure to the Wachovia loan portfolio by $27.7 billion over a period of two years. At the end of 2010, option ARMs represented 60 percent of the acquired Wachovia portfolio, down from 96 percent at the end of 2008.

Wells Fargo, in its fourth-quarter credit supplement, predicted a minimal level of recasting of its option ARMs over the next three years. About $37 million or 175 loans will recast in 2011; $72 million or 282 loans will recast in 2012; and $307 million or 1,033 loans will recast in 2013.

Wells Fargo has $4.1 billion in Pick-A-Pay loans that are classified as nonaccruals, meaning they are nonperforming. Of this amount, 9 percent are actually performing modifications that can be moved to accruing status if they make on-time payments for six consecutive months.

Chase Home Loans’ strategy

JPMorgan Chase inherited a sizable $40 billion portfolio of option ARMs when it acquired Washington Mutual, according to an executive from JPMorgan Chase & Co., the parent company of Chase Home Loans, Iselin, New Jersey.

Chase Home Loans has reworked about one-fourth of the WaMu loans, representing about $10 billion, and expects to adjust another $2 billion to $4 billion of those loans.

“We literally pre-approve people and send them a piece of mail that says, ‘We’re going to allow you to continue paying what you do now,’” says David Lowman, chief executive officer for home lending at JPMorgan Chase, who made the comment to Bloomberg on Feb. 2, 2010. “As you might expect when banks make a great offer like that, people tend to take us up on it,” he added.

Wells Fargo announced last December that it had signed an agreement with the state government of California that option ARM borrowers in that state can earn principal reductions by making payments on time. Lowman has stated that the “super-majority” of its customers in California are making loan payments on time even though many are upside-down with mortgage amounts that exceed the current value of their homes.

The loan modifications have included principal reduction, partly because there is not much more that can be done to reduce payments by lowering the interest rates. That’s because option ARMs, tied to LIBOR, already have very low interest rates, according to a Chase Home Loans executive.

There are about 125,000 WaMu loans that remain outstanding, and the average balance is about $300,000, according to Chase Home Loans.

Lowman testified to the Senate Banking Committee on Nov. 16, 2010, that Chase had done 1 million loan modifications since January 2009, completing more than 250,000 permanent modifications under HAMP, Chase’s own proprietary loan modification programs and modification programs offered by the GSEs, FHA and VA.

In its fourth-quarter earnings, JPMorgan Chase reports it has offered 1,038,000 loan modifications and completed 285,000 since January 2009. Of these, half were modified under Chase programs and rest were under government-sponsored or agency programs, according to JPMorgan Chase’s chairman and CEO Jamie Dimon.

In addition, Chase has its own proprietary modification programs and has participated in other programs offered by Fannie, Freddie, the FHA and the Department of Veterans Affairs (VA), according to Lowman.

Multi-track approach

Chase has prevented more than 429,000 foreclosures, while also completing 241,000 foreclosures. “In other words, during the last two years, Chase has successfully prevented about two foreclosures for each one we have completed,” Lowman testified.

Lowman told the Senate committee that Chase had set up 51 homeownership centers in 15 states and the District of Columbia, and Chase employees had met with 115,000 struggling borrowers to modify loans. In addition, Chase made 341 million outbound calls to borrowers to inform them of modification alternatives.

Lowman also testified that Chase had been proactively involved with modifying option ARMs. “To eliminate any potential payment shock, we offer to modify the loan to a fixed payment, keeping the borrower’s monthly payment at its current amount,” he told the Senate Banking Committee. “For the majority of these modifications, the borrower’s payment is fixed for the life of the loan.”

When Chase modifies a loan to keep the payment at the same level before it adjusts, it is converted into a loan that will pay down principal on a normal amortization schedule. When Chase cannot get the modified payment down to its current level to avoid a payment shock, it does a sufficient amount of principal reduction to accomplish that goal.

The principal reduction is necessary to avoid the alternative, which is a foreclosure, according to a Chase executive. “We’re avoiding foreclosures. That’s what we’re getting. That’s what we want,” the executive said.

Pay option ARMs automatically recast when the principal builds up to 110 percent or 125 percent of the original home value. For those who paid the minimum payment, each month they owe more and more until they hit the recast ceiling. “Once you get to 110 to 125 percent, it turns into an amortizing loan,” a Chase executive says. At this point, the borrower is paying both interest and principal and would be facing payment shock. Chase’s loan modifications are aimed at getting the borrower past the point when the loan recasts. 

With option ARMs, the problem may not be that the borrower no longer has equity in the home. Many, in fact, may have considerable equity but cannot afford the higher payment once the payment recasts. “When you go to an amortizing loan with principal and interest, there is going to be sticker shock,” the Chase executive says.

In its fourth-quarter earnings, JPMorgan Chase reported that it had added $2.3 billion in loan-loss provisions. This included a $2.1 billion increase in the allowance for loan losses for the WaMu purchased credit-impaired loan portfolio. “The impairment . . . reflected an increase in estimated future credit losses and was largely related to home equity and, to a lesser extent, option ARM loans,” the company stated in a press release.

Bank of America Home Loans's approach

Bank of America Home Loans, Calabasas, California, has made perhaps the most progress in moving pay option ARMs off its books. According to a company source, nearly two-thirds of 458,000 option ARMs funded by Countrywide prior to the acquisition “are no longer on the books” at Bank of America.

That leaves Bank of America with 156,000 active option ARM loans. One-third of those, 52,000, have five-year recasts. The other two-thirds have 10-year recasts and will not begin recasting in significant numbers until the end of 2014--“if they are still active by then,” a source says.

“Of those [that] have recast, more than half experienced less than a 20 percent payment increase, and many experienced a payment decrease,” the source says. “The same is forecast for 2011.”

Bank of America Home Loans has done more that 775,000 loan modifications since January 2008, and has completed 102,000 permanent HAMP modifications through December 2010.

The bank has completed 664,000 modifications in its proprietary National Homeownership Retention Program (NHRP), which was launched in October 2008 in cooperation with state attorneys general. The program is not only for borrowers with option ARMs, but also for some subprime loans and prime two-year hybrid mortgages that were originated by Countrywide.

The program first looks to provide principal reductions to arrive at an affordable payment through an earned principal forgiveness approach “to severely underwater loans,” a company press release states.

There is also principal forgiveness through a reduction of negative amortization that has occurred under some option ARMs. Bank of America also attempts to convert option ARMs to fully amortizing loans before the recast. The program is available for borrowers with mortgages with a principal balance of 120 percent or more. The program is set to continue through the end of 2012.

The principal-reduction effort is designed to reduce the monthly payment to 31 percent of household income. Bank of America will, under the HAMP Principal Reduction Alternative program, reduce loans to as low as 95 percent of LTV, according to a company press release. Bank of America Home Loans will also do a “pre-emptive modification” for loans about to recast to convert the loans to one that is fully amortizing at a market rate.

Under Bank of America Home Loans’s HAMP principal-reduction program, the reduction is available for up to 30 percent of the balance of the loan, so long as it does not reduce the loan below 100 percent LTV.

In Bank of America Home Loans’s earnings statement for the fourth quarter, the company reported that the provision for credit losses was lower by $2.8 billion due to improving loan performance trends in the Countrywide purchased credit-impaired home-equity portfolio. The provision for credit losses for year-end 2010 was $8.49 billion in the home loans and insurance business segment of the bank’s businesses, compared with $11.244 billion at year-end 2009.

Some see moral hazard

Some banking experts view the growing practice of allowing earned principal reduction and principal forgiveness as something that will come back to haunt the business. They believe the approach creates moral hazard that could lead to more loans going delinquent. That is the view of Dick Bove, senior vice president of equity research for Rochdale Securities LLC, Stamford, Connecticut.

Bove believes the principal-reduction programs “set a bad precedent” that binding contracts can be broken whenever borrowers get in over their heads and lenders are compelled to make up for the mistakes borrowers make in applying for loans they cannot afford.

These programs send a signal that borrowers who continue to pay their mortgages on time are “stupid,” Bove says. “I don’t why they should be paying their mortgages.” If they were “smart,” he says, they would stop paying them to get a principal reduction.

Bove contends that the negative fallout from abrogating contracts selectively will be significant and will hit in ways people may not anticipate.

For example, if a borrower who has received principal forgiveness goes to sell his house, he can take a lower sales price. This, in turn, will lower the value of surrounding houses, according to Bove. “We don’t give a damn about the guy who lives next door,” he adds, who kept paying all along on his much higher mortgage, while his resale value has subsequently plummeted.

Further, to cover the cost of principal reductions on selected loans, interest rates for all other borrowers will have to rise, which, in turn, will push down home prices, all other things being equal, Bove predicts.

Principal forgiveness also can be harmful to bank shareholders and, to the extent it encourages more borrowers to stop paying their mortgages, it does not achieve the goal of reducing overall losses, according to Bove.

The underlying message from principal reductions being done voluntarily or under pressure from state attorneys general, Bove says, is that, “If people can’t pay their mortgages, then obviously the banks screwed them.”

Finally, when the principal reductions involve investors in mortgage-backed securities, it also makes investors less willing to invest in such securities in the future for fear of principal reductions for borrowers unable to make their payments. This, in turn, will reduce the amount of funding available for mortgages, according to Bove.

Bove recommends instead that banks foreclose on borrowers who cannot afford their payments. That, in turn, will be better all around. “If a person doesn’t have the ability to pay a mortgage, he should be foreclosed on and he should be living in an apartment,” says Bove. By having his living expenses greatly reduced, the former homeowner can begin to rebuild his finances and credit--something that will be difficult if he stays in a house that is a financial burden.

Finally, Bove blasts the attorneys general who want to impose principal reductions on mortgage servicers across the nation. “Basically, who elected them? All the [defaulted borrowers] or all the people who pay their mortgages?,” he asks.

The state attorneys-general proposal

On March 3, 50 state attorneys general issued a 27-page term sheet that outlined the requirements they want to impose on the five largest mortgage servicers. Among other things, the proposal would require that loan-modification programs, including principal reductions, also cover second liens.

The attorney general who has issued press releases for the 50 state attorneys general is Iowa Attorney General Tom Miller. The coordinated multistate working group is headed up by an Executive Committee representing made of attorneys general from 12 states: Arizona, California, Colorado, Connecticut, Florida, Illinois, Iowa, New York, North Carolina, Ohio, Texas and Washington. The 50-state attorneys general investigation into mortgage servicers followed the finding last fall that the largest mortgage servicers were using faulty affidavits to improperly foreclose on homeowners.

The proposed settlement includes such features as ending foreclosure proceedings for any borrower currently being considered for a loan modification. Servicers would be forced to consider offering a modification, including principal reduction, before moving forward to foreclosure.

At least four attorneys general, however, see the proposed settlement as an over-reach with harmful consequences. The four are Florida Attorney General Pam Bondi, Texas Attorney General Greg Abbott, Virginia Attorney General Kenneth Cuccinelli and South Carolina Attorney General Alan Wilson.

“Because of the term sheet’s vague principal-reduction standards, some homeowners may simply default on their loan and use the states’ agreement to obtain a principal reduction--whether or not they actually made an effort to maintain their mortgage,” the four wrote in a March 23 letter to Miller.

“In our view, the 50-state working group has a unique opportunity to address the mortgage servicers’ legal and financial malfeasance on a national scale--but we are concerned that expanding beyond the scope of our already expansive charge may ultimately undermine the effectiveness of law enforcements efforts,” the letter stated.

Meanwhile, the Republicans in the House moved to terminate the HAMP program, leading a group of lawmakers to write a letter to Treasury Secretary Timothy Geithner on March 28 calling on him to reform HAMP in order to save it from termination.

As servicers continue the long, hard struggle to contain losses from loans made during the peak of the bubble, option ARMs will continue be perhaps the most difficult to resolve in a way that minimizes losses.

To the extent the option ARM saga can be brought to a close, it will be an important milestone in the overall journey to bring delinquencies and foreclosures down to historical norms.  MB

Robert Stowe England is a freelance writer based in Arlington, Virginia. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

Copyright © 2011 by Mortgage Bankers Association. Reprinted with Permission.



Robert Stowe England is an author and financial journalist who has specialized in writing about financial institutions, financial markets, retirement income issues, and the financial impact of population aging.

Visit Mind over Market:

Mind Over Market

Click Here>>