Are Liar Loans Going to Get Principal Reductions?

The announcement by Bank of America (BAC) of their plan to offer up to 200,000 struggling homeowners a new lease on life for their underwater mortgage through principal reduction at first glance seems like a major step forward in addressing a nearly 5-year old problem.

Principal modifications are the mortgage industry's third rail issue, fraught with passion on both sides of the debate over the merits of such programs. The attention given to FHFA Acting Director DeMarco's seeming reluctance to allow the GSEs to deploy such measures is a case in point.

Many economists favor principal forgiveness over interest rate reduction or term extension modifications based on the idea that reducing principal will lower the likelihood that the borrower will redefault by lowering the negative equity position.

Moreover, some embattled lenders seem to have capitulated against federal and state mortgage legal actions by touting principal reductions that up to now were used only sparingly.

The real value of principal reduction comes down to determining the borrower's behavior toward that program. For current but underwater borrowers, a concern that's been levied and to this day remains unknown is the ruthlessness by which such borrowers, realizing that there may be an opportunity to receive a principal modification upon going 60 days delinquent, exercise their default option to obtain this lucrative debt elimination offer (often referred to as strategic default). Much depends on the friction costs such borrowers face in the form of damaged credit, relocation expense and other assorted costs.

As one can imagine, the value of that option depends on how much principal reduction the borrower might receive. In the Bank of America announcement, this could be as much as $150,000, certainly an amount that would make most people take notice. Bank of America has taken actions to forestall such attempts to allow strategic default by requiring all borrowers for principal reduction to pass a hardship test. That would eliminate those borrowers current on their mortgage but otherwise with motive (i.e., underwater) and intent to default. For eligible borrowers that are both delinquent and underwater, the prospect of principal reduction is conveyed in terms of net present value against alternatives. A primary determinant of whether a principal reduction modification is economically attractive over other modification alternatives is the borrower's propensity to redefault on the new modified mortgage later.

The poor results of the government's modification efforts provide some evidence that interest rate and term extension modifications have not worked, leaving the door open for more principal reductions. In option theory terms, a principal reduction modification reduces the option strike price, which lowers the attractiveness of defaulting in the future. But while lowering the borrower's loan-to-value ratio to 100% from say 140% certainly helps lower that chance of redefault, it does not eliminate it and much depends on what's going on inside the head of the borrower. And as it turns out, there is a large segment of the borrower population that is eligible for a principal reduction modification that may have already tipped their hand in terms of their intent to take advantage of such programs.

Lurking below the surface is an ugly and messy public policy problem – namely what to do about the group of delinquent and underwater borrowers who were not truthful with lenders regarding their ability to repay their contractual debt obligation. In the vernacular, so-called "liar loans" typified by the alphabet soup of products with such names as SISA (stated-income, stated-asset) and NINA (no income, no asset) blossomed during the housing boom. But what is interesting is the virtual silence on the millions of borrowers who consciously signed loan documents knowing that their income was overinflated well beyond justifiable levels. Quality control departments during the boom tracked these developments against actual IRS 4506 tax documents with common results showing that high percentages of these loans had overstated their incomes by at least 50%.

Now, to be sure, some coaching and documentation errors by lenders and mortgage brokers explain some part of this phenomenon, however, it cannot explain the majority of this problem. The Bank of America program does not disqualify such borrowers from receiving principal reductions and therein lays a terrible credit and public policy precedent. Beyond the fact that rewarding such borrowers who intentionally deceived lenders and security-holders by making false statements regarding their income and assets goes against principles of living by the golden rule, it exacerbates a troubling trend in borrower behavior that developed during the housing boom. That is, historical stigmas of excessive leverage and delinquency, which were powerful drivers of low mortgage delinquencies for decades, underwent a fundamental yet subtle transformation, exhibited by radical changes in borrower payment hierarchy and a higher incidence of personal bankruptcy observed in recent years as well as in other forms.

Anyone with a mortgage — delinquent or current that went through the effort to fully document their income and assets ought to be incensed over this policy and demand that no principal reduction program — private or public be permitted for borrowers who took out these more egregious form of low doc mortgages.  It incents some borrowers to pursue strategies to game the system, and while great focus has been given the other direction; namely establishing policies to mitigate predatory consumer lending practices, lenders and policymakers must not reinforce behavior that also contributed to the collapse of the mortgage industry.

Clifford Rossi is an executive-in-residence and Tyser Teaching Fellow at the University of Maryland's Robert H. Smith School of Business. He has held senior risk management and credit positions at Citigroup, Washington Mutual, Countrywide, Freddie Mac and Fannie Mae.