Negative Equity Is Driving Principal Reduction Push

WASHINGTON-Negative home equity is causing advocates of loan modification to see principal reduction as a necessary step to make mods work.

The Federal Deposit Insurance Corp. led the way on the loan modification front in 2008 when it launched a program for reducing monthly payments for struggling borrowers at the failed IndyMac Bank. Now, FDIC chairman Sheila Bair is moving toward an industrywide principal reduction program. "The initial phases of the crisis involved poorly structured mortgages that posed an affordability problem," she told a recent meeting of minority real estate professionals. "Now we're dealing with underwater mortgages."

Ms. Bair noted that negative equity is driving principal writedowns within the agency's loss-sharing agreements and other failed bank programs. Ron Faris, who manages specialty servicer Ocwen Financial Corp., told a congressional panel recently that negative equity is the primary driver of redefaults on modified loans.

Redefaults are particularly severe when the mortgages have loan-to-value ratios above 125%, he said. "Approximately 15% of Ocwen's loan modifications since the onset of the mortgage crisis involve some element of principal reduction," he said. (Ocwen's redefault rate is about half of the industry's average, the company says.)

House Financial Services Committee chairman Barney Frank, D-Mass., contends that the Obama administration's loan modification effort has "fallen short," saying now is the time to focus on principal reductions. The committee chairman believes that many investors are willing to accept principal reductions of first mortgages that are underwater, except the nation's largest banks.

Bank of America, Citigroup, JPMorgan Chase and Wells Fargo-which combined own $452 billion in seconds-have become an "obstacle" to principal writedowns, he said.

In a recent letter, the committee chairman urged the banks "to take immediate steps to write down these second mortgages and allow principal reductions of the underlying first liens to take place." Rep. Frank noted that the Treasury Department and FDIC are willing to work with the banks on accounting and regulatory capital issues to lessen the impact of writing down seconds.

A JPMorgan Chase spokesman declined to comment on Rep. Frank's letter, saying the bank will communicate directly with the chairman. Chase owns $134 billion in seconds with $33 billion deemed credit impaired with a carrying value of $26.5 billion.

Citigroup has been modifying second liens for some time, according to mortgage group spokesman Mark Rodgers. "We also continue to work closely with Treasury to address concerns related to second liens," Mr. Rodgers said. He noted that Treasury has developed a program for modifying second liens. Citigroup and others are waiting for the release of Treasury's final guidelines.

The new effort is aimed at getting banks to modify the second liens they own when the corresponding first mortgage is modified. It is unclear if Treasury officials, when the final guidelines are issued, will require principal reductions. Citigroup has $54 billion in second mortgages.

Bank of America is the only bank that has formally signed up to participate in Treasury's second-lien program. B of A agreed to modify its second liens regardless of whether it also services the first. Still, the bank (saddled with billions of dollars in troubled seconds from its 2008 purchase of Countrywide) is waiting for Treasury to issue its final guidelines.

"We expect to replace the existing guidance with updated language very soon," said an agency spokesman. B of A has $172 billion in second liens. Roughly 80,000 of its 3 million home equity accounts have been modified in the past two years.

Spokesman Rick Simon said B of A generally modifies seconds when it owns the first, allowing the borrower to have an affordable payment on the combined mortgages. B of A initiated principal reductions on pay-option ARMs a couple of months ago.

"On option ARMs, we felt it is an appropriate use of principal reduction," Mr. Simon said.

Wells Fargo plans to participate in Treasury's second-lien program. "We have been actively working with the government to understand specifics of how the program will impact second liens so that we are prepared to act quickly once we receive the final program guidelines," spokeswoman Mary Berg said.

Wells Fargo has a $124 billion home equity loan portfolio.

"In the meantime, we continue to help as many customers as we can find options to help pay their home equity loans through our own modification programs," Ms. Berg said.

Jim Park, president of the Asian Real Estate Association of America, said principal reduction is needed to reset the incentives for borrowers to remain in their homes-particularly in markets where the negative equity situation may not resolve itself for a long, long time. Until we deal with the negative equity situation in direct way, we are going to have a hard time creating a sustainable situation for these homeowners," he said.