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Fitch Says Principal Forgiveness Alone Does Little to Make Mods Work

While servicers are increasingly forgiving some principal when they modify troubled home loans, debt reduction alone appears to have little impact on redefault rates, according to Fitch Ratings.

Fitch said servicers are expanding their use of principal forgiveness in loan modifications, but initial data do not suggest this has much impact on redefault rates. The ratings agency found that even with principal forgiveness of 20% or more of the loan amount, 28% of loans redefaulted within six months. That compares to a 30% redefault rate on loans where the outstanding principal increased on a modification due to the capitalization of past due interest and other costs.

However, that is significantly below the overall default rate on modified loans. Fitch predicts that redefault rates will remain elevated, projecting that 60% to 70% of modified loans will redefault within 12 months. Fitch said its bleak prediction is based on the use of streamlined modification procedures, where income is not verified. Rising unemployment and falling home values are also factors reducing the success rate on mods, Fitch said. By contrast, Fitch said modifications that reduce the borrower's monthly payment do appear to reduce the redefault rate. Reducing the borrower's payment by 20% or more lowered the redefault rate to 21%. That compares to a 49% redefault rate for modifications where the monthly payment increased by 10% or more due to the capitalization of arrears.

Diane Pendley, managing director and head of Fitch's operational risk group, said modifications that include some combination of payment reduction and either principal forbearance or forgiveness may be the most effective approach to modifying mortgages so that borrowers are able and willing to stay current on the new loan.

"When principal forgiveness is used as opposed to forbearance where a portion of principal is ballooned to the end of the term, it should be carefully considered and tied to the current value of the home," Ms. Pendley said.

She said some servicers are reducing the targeted, post-modification payment-to-income ratio because this ratio typically omits the borrower's consumer loan and second mortgage payments.