The U.S. Treasury announced plans in late March to incorporate principal reductions as part of the Home Affordable Modification Program (HAMP) for distressedborrowers who owe more on their mortgage than the home is worth. The move has sparked a heated debate over the ramifications of mortgage debt forgiveness.
On one side, proponents argue that negative equity has become one of the primary triggers of default, and of re-default even after the original mortgage is modified using the typical waterfall of rate reductions and term extensions – when plagued with negative equity, borrowers essentially have little at stake in keeping their homes. Supporters of an industry-wide initiative to slash outstanding principal when it towers above the property’s value say it’s a strong incentive for homeowners to stay current on a newly modified loan and could deter delinquencies in a market already saturated with defaults.
On the other side of the fence, critics question the fairness of the principal write-down practice when most homeowners are continuing to pay their mortgages every month, some of them cutting corners and tightening their belts to do so. Other opponents are asking just where do you draw the line – is a mortgage no longer a contract that carries with it a pledge by the borrower to repay the amount of money agreed upon? They say mandates to retroactively rewrite the loan amount could have serious implications for the future of lending and the risks associated with extending credit.
According to commentary released this week by analysts at the credit ratings agency DBRS, as a modification technique, debt forgiveness has long been regarded as controversial in the mortgage industry due to its moral hazard risk and the potential impact to the performance of mortgage-backed securities (MBS). As a result, the firm says this particular form of modification has been utilized on a very limited basis by mortgage servicers.
DBRS points out, though, that the new HAMP directive for principal reductions, which isn’t expected to be operational until this fall, aims to reduce the moral hazard risk by encouraging borrowers to be more responsible over time. HAMP servicers are required to consider debt forgiveness as an alternative modification by reducing the principal balance of the loan to 115 percent of the current value of the home. Servicers will initially treat the write-down amount as forbearance and will forgive the forborne amount in three equal steps over three years, as long as the borrower remains current on payments.
The ratings agency says investor reactions to the government push for an increase in debt forgiveness has been mixed at best.
Senior and subordinate bondholders often have split views on the issue because in a traditional debt forgiveness scenario, the principal forgiven will be treated as security losses and be absorbed first by subordinate holders. Many investors who in recent years bought subordinate bonds based on their “interest-only” values will see these bonds deplete faster than initially anticipated, DBRS’ analysts explained. Senior investors, on the other hand, while losing some immediate credit enhancement, may benefit from such modifications, as overall cumulative losses should lessen in the long run.
Even within the senior bondholders’ class, DBRS says super senior and senior mezzanine investors may also disagree on debt forgiveness. Although both are senior bonds, certain senior mezzanine tranches will likely benefit more when principal is forgiven. The agency’s analysts explained that this would occur if the subordinate write-downs cause the “cross over” from sequential to pro-rata pay among all senior bonds to occur sooner, allowing the senior mezzanine bonds to start receiving principals sooner than expected.
“If done properly, DBRS believes that transactions should, in the long run, benefit from principal forgiveness,” the company’s analysts wrote. “Although securities average lives may be extended, some borrowers could prepay and cumulative losses could be reduced if the housing market recovers in the next few years.”
DBRS says implementing debt forgiveness may also moderate the ever-increasing delinquency pipeline by curtailing roll rates from 90-plus days delinquent to foreclosure and from foreclosure to REO, and as a result will help shrink the housing supply and trim down distressed sales in some regions.
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