Banks May Start Reducing Distressed Homeowner's Principal

The estimated 7 million foreclosures that are expected to hit in 2010 may force banks to reduce principal in a desperate attempt to keep homeowners paying their loans. Homeowners have little incentive to stay in their homes if they owe much more than their home is worth, but banks would have to declare huge losses if the masses walked away from their loans. See the following post from Expected Returns.

From Bloomberg, Principal Cuts on Lender Menus as Foreclosures Rise:

Efforts by U.S. banks to help distressed homeowners have focused mainly on temporary fixes such as interest-rate reductions that may only put off the day of reckoning, despite policy makers wanting them to do more.

Banks may be forced to resort to a remedy they’ve been trying to avoid -- principal reductions -- as another wave of foreclosures looms and payments on risky loans rise, Bloomberg BusinessWeek magazine reports in the Jan. 18 issue.

While interest-rate reductions or extending loan terms reduce homeowners’ monthly payments, they don’t give much comfort to borrowers who owe more on their homes than their properties are worth. Borrowers who don’t have equity in their homes are more likely to hand over the keys when they run into trouble. “The evidence is irrefutable,” Laurie Goodman, senior managing director of Amherst Securities Group in New York, testified before the U.S. House Financial Services Committee on Dec. 8. “Negative equity is the most important predictor of default.”

Banks are reaching maximum levels of desperation, perhaps because they know 2010 will be the year of the foreclosure. Please revisit last month's Wall Street Journal article, one in four borrowers is underwater, to get a sense of the severity of the housing crisis. As long as the labor market remains weak, housing will not recover meaningfully.

Also take a look at this article in today's Wall Street Journal, which explains that apartment vacancy rates are at 30-year highs. When rents go down, housing prices go down with it. This readjustment process in price to rent ratios will take some time to work itself through.
Extend and Pretend

The foreclosure crisis is likely to deepen this year in part because payments on many adjustable-rate mortgages are set to balloon. Unless there’s a sharp recovery in property values or a change in lenders’ willingness to cut principal, at least 7 million borrowers currently behind on their payments will lose their homes, Goodman estimates.

Some lenders may be coming around to the idea of principal reduction. “If you can right-size the mortgage and return to an equity situation, the incentive is to stay,” says Micah Green, an attorney at Patton Boggs in Washington and a lobbyist for a coalition of mortgage bond investors. Banks can either forgive principal outright or defer it. In deferrals the borrower must pay back the full amount on the original mortgage when he sells the property; if the ultimate sales price doesn’t cover the principal, the homeowner has to pay the difference, making it a less effective tool.

Our banking system has degenerated to the point where banks defer losses through the process of "extend and pretend". Primarily in the commercial real estate complex, banks are extending loan maturities in the desperate attempt to recoup their loaned money. The logic here is that by extending loans, banks can avoid massive writedowns in non-performing assets. This, of course, assumes that real estate prices will magically recover to bubble valuations. Absent a miraculous housing recovery, banks are sitting on huge losses.

The next wave down in housing will come as a surprise to most, even though the warning signs are flashing everywhere. We are in the middle of a secular downtrend in housing that will drag down our economy for years to come. I expect confidence to trough once again in 2010 as the economic recovery is proven to be an illusion. I believe this crisis in confidence will be centered around our banking system, which will be very supportive of gold prices.

This post has been republished from Moses Kim's blog, Expected Returns.