Principal reductions, such as those agreed to in the state AG settlement with five large servicers, may help residential MBS performance in some ways but hurt in others, according to a new report from Fitch Ratings.
There can be benefits from the reduction in equity that can make loan payments more affordable for borrowers, but these need to be weighed against the potential increase in moral hazard risk, the ratings agency said.
“Equity is the primary driver [of defaults] but it's not the only driver,” Suzanne Mistretta, senior director at Fitch, told this publication. “There are other risk factors that you can't address with a principal cut. You do see borrowers in positive equity positions still defaulting.”
Fitch has found principal reduction modifications perform better than restructurings involving a rate or payment cut. But the ratings agency said re-default rates for principal reduction mods with deep payment cuts still are above 20%.
Most of these re-defaults stem from high non-mortgage consumer debt-loads that remain after mortgage modification. Servicers may use the back-end debt ratio that represents the portion of a borrower's income used to pay total debts to make the payment sustainable.
But Fitch noted that this results in a situation where the first-lien investor is essentially subsidizing the repayment of other consumer debts. This potentially can be a moral hazard encouraging other borrowers that are leveraged/underwater to default in an effort to obtain similar payment reductions, the ratings agency suggested.
A targeted plan for borrower eligibility and payment decreases limited to “reasonable” payment-to-income ratios might be the best way to balance the pros and cons of principal reduction, according to Fitch.
“If you limit it, you're not going to lure as many people into voluntarily defaulting,” said Mistretta.
