The hundreds of millions of dollars being spent on principal reduction for “underwater” home owners is a poorly designed program which arbitrarily rewards some delinquent borrowers and punishes others who have struggled to remain current in their obligations. It will have some limited success in allowing owners to remain in their properties, but at a great cost to taxpayers and banks.  And, it is unnecessary as a better plan that would require no new capital could be enacted. It would require banks to honestly evaluate the value of their assets and have a proactive approach to maximize this knowledge, characteristics which thus far they have failed to exhibit.

Borrowers and lenders are on the same side of the equation.  When property values maintain or increase, both parties benefit; lenders are more secure and borrowers/owners have motivation to protect their equity.  The bane of both parties is foreclosure.  When this occurs, not only do both lose, but other owners and lenders in the area suffer. Foreclosures lead to further disintegration in values, borrower disincentives and additional foreclosures.  A primary goal of any plan must be foreclosure avoidance.

Here is another option.

The plan

All borrowers having homes worth less than the mortgage amount owed would be eligible for a refinance of the amount owing with principal only payments.  The interest rate would go to zero – the total payment applying to principal. This would continue until the amount owing is equal to 90% of value, at which time the lender makes a new principal and interest loan at standard lender fees.  The borrower’s payment is set at the rental value of the house including impounds for property taxes.

An example

The bank is owed $200,000 on a residence that has a current value of $150,000.  The borrower’s monthly payment becomes the rental value of the house (say $1,600) including property taxes ($150).  The lender then credits $1,450 towards the principal.  After 36 months the borrower has reduced the principal by $52,200 and owes $147,800. Thus, the residence would need a value of $164,222 ($147,800/90%) to obtain a new loan. This is a realistic valuation were there few or no foreclosures during the period.

Why it works

This plan works because each party benefits in its success.  The property in the example has a high risk for default.  Should the borrower be forced to choose between paying a medical bill or his mortgage, he may fall behind on his loan payment.  Once behind, there would not be enough incentive to become current.  The results of a foreclosure would result in the lender receiving the value of $150,000 less costs of foreclosure, maintenance, repair and resale, with estimated net proceeds of $130,000.  Instead, with this plan, the lender would receive $52,200 in principal and a new, well-secured note of $147,800 for a full return of the $200,000.

A major defect of current loan revisions is the high percentage of re-defaults; borrowers not living up to the renegotiated terms.  Underwater borrowers are very willing to accept any plan, no matter how ill-suited, to buy additional time.

This plan would have a re-default rate approaching zero.  Each month the borrower is paying an amount that would have to be paid in rent.  Each month by paying this rent equivalent, he is instead depositing $1,450 into savings, which after 36 months will give him a house with over $16,000 in equity.  There would be incentive to pay additional principal and accelerate the process because a new loan at 4%, (slightly more than today’s rate) would have a monthly payment of only $706, a major reduction.  And this low payment provides a tremendous new level of security for both parties as lenders can be confident that a borrower able to maintain the $1,600 payment will have no difficulty with one cut by more than half.

The success of this plan could ripple through the economy.  Stable property values increase property taxes and re-establish a real estate market; one that is defined by a seller using equity from a sale to acquire another, usually more expensive, residence.  Currently, there are transactions, mostly of financial necessity, in which the seller ends up without funds and is forced into the already-stressed rental market. When recipients of current principal reduction funds from the government/bank program sell and attempt to repurchase, they will undoubtedly have a “charge off” or the equivalent on their credit, hindering them and the marketplace.

This plan, as with the government’s HARP and others, can only be fairly examined if lenders accurately assess their situations. A loan of $200,000 secured by property worth $150,000 is not an asset of $200,000, despite how it may appear on the books, but one valued at approximately $130,000.  Only with this valuation to compare can lenders take the next prudent step.

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