Seeing Through Data

Principal writedown, erasing part of a mortgage debt usually to avert foreclosures, has become a raging debate.

There is nothing new about the concept of principal writedown.  In many ways it remains the core tenant of Chapter 11 and 13 bankruptcy, the former usually for businesses and the latter for individuals.  Chapter 11 is oftentimes not even referred to as “bankruptcy” but by the gentler name “reorganization.”  In contrast, Chapter 7 is liquidation, where the assets of an individual or a company are sold, their debt eliminated, and the business shuts its doors or the individual theoretically starts over again.

Principal writedown is a growing but still seldom-used method used to modify mortgages, typically when the value of a house is substantially worth less than the amount owed.

Let’s examine some interesting figures from the latest quarter report from the Office of the Comptroller of the Currency (OCC), entitled “OCC Mortgage Metrics.” I’ve uploaded some of the data tables in the report to a downloadable spreadsheet, here.

Principal writedown is present in 7.8% of the 137,539 Q3, 2011 mortgage modifications.  Only private lenders cut principal, probably because the notion tends to leave neighbors livid even if it’s the right solution.  Private bankers make rational economic decisions, whereas government officials are clearly bound by political constraints based upon what the neighbors think.

It’s in the neighbors best interest to reduce principal and avoid foreclosures, since it keeps their own property values propped up, though it irrationally leaves them livid.

Before examining principal writedown itself, let’s look at various types of loan modification the OCC reports on: capitalization, interest rate reduction, interest rate freezing, term extension, principal reduction, and principal deferral.  [Note as we walk through the numbers: since mods often involve more than one aspect figures often sum up above 100%.]

Capitalization is, by far, the most common loan modification method used in 88.5% of all mods in Q3, 2011. Capitalization is troubling in that it takes a borrower who is already in trouble and puts them in worse trouble by adding missed payments and fees to their already unaffordable balance.

Increasing zombie-debt sounds like exactly the wrong thing to do for both bank and borrower, but thanks especially to Fannie Mae, Freddie Mac, and other government-guaranteed loan modifications capitalization is the most common element of all modifications.

Capitalization was used in 86.6% of Q3, 2011 modifications for prime loans, 89.5% of Alt-A mods, 88.3% of subprime mods, and 93.4% of the large but nebulously named “Other” loan type.  In contrast, principal reduction was used in 5.5% of prime mods, 8.7% of Alt-A mods, 12.3% of Subprime mods, and 4.6% of “Other” loan types.

Private investors are more willing to modify a loan to see if it will perform, probably on the notion that if restructuring will not work the debt should be written off.  That is, they’re more likely to encourage either positive or negative resolution.  Private banks appear wary of zombies.

In contrast, government-backed loans appear more likely to favor measures to keep the loan “alive,” without reducing principal.  We’ve heard of zombie-like bureaucrats in DC; it stands to reason that they’re comfortable with their financial equivalents.  Fannie, Freddie, and government guaranteed (FHA, VHA, etc..) mods included capitalization at 96.8%, 99.1%, and 98.3% respectively.  In contrast, 85.3% of loans held by private investors and 67.4% of loans held in portfolios involved capitalizations.

Jammed-up government-backed borrowers are more likely to receive term extensions.  Fannie, Freddie, and government-backed term extensions exist in 68.1%, 69.5%, and 84.4% of their respective mods.  In contrast, just 24.2% and 36.5% of portfolio loans involve term extensions.  This suggests the private market prefers their loans either alive or dead; they’re trying to move beyond extend and pretend.

None of the government-backed loans agree to reduce principal whereas 15.3% of loans by private investors and 18.4% of portfolio loans involve principal reduction.  Similarly, principal deferral — the process of moving principal later in the life of a loan when the house might have more value — is present in 25.6% of Fannie’s mods, 18.2% of Freddie’s, and .1% of those guaranteed by the government (that’s not a typo).  However, this more borrower-friendly method for making loans affordable is present in 23% of loans held by private investors and 29.2% of portfolio loans.

Modification success is broken into two series of reports, one towards the top of the report that summarizes success over all time periods lumped together and a more useful series, buried further down, that breaks down success using more granular time-based reporting.

Even with lousier borrowers, it’s clear the private market does a better job making mods.

For 2008-2010 modifications the success rate — the rate where borrowers did not re-default after a year — was 61.6% , 46.8%, and 26.4% for GSE and government-backed loans.  In contrast, private and portfolio loan 12-month re-default rates were 50.6%, 38.6%, and 23.7%.

The summary report, lumping together all times, paints a rosier picture for the government for 12-month re-default rates.  Fannie and Freddie both report a 28.2% re-default rate, government-guaranteed loans had a 50.8% re-default rate, private portfolio loans come in at 48.3% re-default rate, and portfolio loans suffer a 25.2% rate.

However, those all-time modifications statistics include the much higher private loan 12-month re-default rates for the 2008 modifications, at 61.2%.  Given that these loans were often to substantially riskier borrowers — think corner-stores where mortgage brokers purchased “Wite-Out” by the case — it’s amazing they lowered their 12-month re-defaults to 29% for the 2010-era mods.

Although private lenders do offer principal reduction, they do so comparatively low rates making it difficult to adequately quantify what effect principal reduction has on modified loans.  [Note: remember again that that most modifications offer some combination of terms, meaning the percentages of loan modified by type of modification exceeds 100% of all modification types.]

In Q3, 2011, lenders offered principal reduction in 10,722 modifications.  In contrast, 121,716 modifications included capitalization, 112,819 included a rate freeze, 79,536 contained a term extension, and 28,133 included principal deferral.

Overall, there were 137,539 loan modifications in Q3, 2011, according to the OCC, so 7.8% contained an element of principal reduction.  That figure is low enough, and the OCC data coarse enough, that it is impossible to draw a definitive conclusion.

Around the web we find colorful depictions of how to slay zombies, or bring them back to life.  It’s apparent that the private market has a good track record of making the right long-term decision when forced to shoulder the downside risk of its own decisions.  Being a basic tenant of capitalism, this shouldn’t be a surprise but it’s still happening all too seldom.