With principal reduction modifications a key component of the preliminary term sheet that was recently released by the State Attorneys General, there has been more attention placed on the success of these loan modification programs and their accompanying moral hazard issues, analysts said.

Amherst Securities Group (ASG) analysts made a case for principal reductions in a report released today. They said that since negative equity drives defaults, principal reduction is the most successful kind of modification. In the report, analysts also offered some recommendations on how to better align incentives to mitigate strategic defaults. 

Aside from this, they also showed evidence that it is "very dangerous" not to do these modifications since doing so only makes the vicious home price depreciation/negative equity cycle worse.

The State Attorneys General Term Sheet, which they called a very preliminary set of settlement terms proposed by the Attorneys’ General to the servicing community after the problems of robo-signing and other questionable market practices were revealed, includes principal reductions as a cornerstone of the settlement.  

ASG analysts have long advocated this strategy as they have witnessed overwhelming evidence that, for borrowers to continue to pay, one needs to re-equify the borrower.

However, this principal reduction feature has caused considerable controversy, analysts noted. Specifically, some market players doubt the effectiveness of principal reduction modifications, while others are concerned about the moral hazard issue they entail.

In the report, analysts reiterated the case for principal reductions and suggested their thoughts on dealing with moral hazard. Analysts argued also that the cost of doing nothing and exacerbating the home price depreciation/negative feedback loop is very high.

Principal reductions are the most effective type of modification, they said. This makes sense since equity is the most important determinant of default. There are many ways to both effect a principal reduction as well as contain the moral hazard issue, they stated. All their ideas are based on as single, simple notion, which is to create "a series of frictions" so that only those borrowers who need this type of modification will take advantage of it. The frictions ensure that fairness issues are minimized as the receipt of a principal reduction entails other penalties.

"We applaud the Attorneys General proposal, as principal reductions are at the heart of their recommended course of action," analysts said.

Principal reduction is the most important supply side measure that can be taken, according to ASG analysts. However, it will not be sufficient to solve the housing crisis.

The demand side measures to increase the buyer base are also significant, they said. Their best pick is increasing the investor role by making financing more accessible to this group of players, analysts said.

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.