Strong interest in more widespread principal forgiveness is commonly said to be the key issue when it comes to the attempt to change the guard at the Federal Housing Finance Agency, but while principal forgiveness is compelling, making it widespread is problematic.
“There is success when you address negative equity,” Frank Pallotta, executive vice president and managing partner, Loan Value Group, said when asked about principal reduction, noting that negative equity remains a “big, big problem.”
But ultimately he said he has a mixed opinion on the issue.
Pallotta has worked both with securitizations and a program addressing negative equity concerns with rewards that can include cash payments to borrowers who continue on-time payments through the loan’s life, and he sees advantages when it comes to loan performance, but disadvantages for securities.
Widespread principal forgiveness would “disrupt the capital markets” as it could widely affect existing securities in negative ways.
As previously noted on this publication’s website, Standard & Poor’s has released reports supportive of the practice, noting that it is still not widespread but growing.
But Fitch has said it could have a mixed impact on private-label residential mortgage-backed securities.
Pallotta agrees that “from a pure performance standpoint negative equity is the main driver of default, period.”
But due to contract law issues, more widely applying principal forgiveness to say, private-label mortgage-backed securities is problematic as it affects the predictability of cash flows and suggests the original contracts they were written under can be changed at later dates.
So while it may prevent default on the surface it is widely said it would affect the “sanctity of the contract.”
The trick is for workout methods to not “touch the note” and this is where principal reduction becomes more viable and workouts can be more flexible.
Note in Freddie Mac’s recent move to begin securitizing modified loans, for example, the loans in question were bought out of its participation certificate securities when the loans were at least 120 days delinquent as is its practice.
The planned securitizations also will not trade in the main and most liquid to-be-announced market, minimizing the possibility of securities market disruption.
The problem for borrowers contending with financial woes and negative equity is it difficult to understand or care that they cannot get a break on their underwater loans because it will disrupt a securities market, unlike it affects retirement/individual investments or a job they may not have.
If the economy turns around and so, too, home values, it may help some borrowers.
But in the meantime it is difficult to see how one could bridge the gap in understanding, motivations and interests between their circumstances and that of the capital markets. As the Standard & Poor’s report noted, principal reduction is making some headway but whether it is “enough” is the question not easily answered.
Among the government moves toward this end that already exist: the Home Affordable Modification Program’s principal reduction alternative, through which borrowers have received approximately $9.6 billion in principal forgiveness as of March 2013.
Also, the attorneys general settlement with top servicers has been cited as a reason its use has increased by Standard & Poor’s.
Pallotta said principal forgiveness is still largely done due to government intervention, although some portfolio lenders do also use it.
Beyond disrupting securities, widespread use of principal forgiveness can be a moral hazard, he noted. So he suggests selective, predictable use of the strategy.
