A number of recent studies have documented the correlation between negative home equity and the incidence of defaults. A report by CoreLogic released in February stated that when negative equity exceeds either 25% of a loan's balance or $70,000, "homeowners begin to default with the same propensity as investors."

While the linkage between the two factors is fairly clear, the full nature of the relationship between homeowner equity and credit performance is quite complex. The impact of weak underwriting has often been masked by rising home prices. Struggling borrowers have often been able to sell their properties rather than go into default, which minimized defaults and investor losses. An example is the 2000 vintage of prime Jumbo loans.

Despite very poor (for the time) credit performance, total losses for the vintage amounted to five basis points, due primarily to strong home price appreciation between 2001 and 2004. The turn in the housing markets in late 2006 and the resulting loss of equity meant that homeowners could not escape financial troubles by selling their properties, without realizing large losses.

The real estate markets also took on an increasingly speculative tone during the bubble years. In addition to outright "flippers," some homeowners who occupied their properties nonetheless viewed them as investment vehicles. It's reasonable to believe that these homeowners are less attached to their properties, and are more willing to walk away from them, than those who view their properties primarily as dwellings. It's also been reported that some homeowners are reducing their housing costs by defaulting on their properties and renting homes.These are probably homeowners who have absorbed the most serious losses on their properties and thus have the most negative equity, since there are costs and repercussions to defaulting.

It's useful to view the behavior of "underwater borrowers" in the context of fundamental consumer credit analysis. Gauging the creditworthiness of potential borrowers involves making two judgments: their ability to pay and their willingness to pay. While many borrowers have had economic circumstances that have impacted their ability to make regular mortgage payments, the decision by some borrowers to walk away from their homes without obvious financial stress represents a change in their willingness to service their mortgage debt.

Viewed in this context, the various proposals for principal forbearance and principal reduction are directed almost entirely at borrowers' ability to pay, as part of a series of modifications designed to reduce their monthly debt burden to a manageable share of income. As an example, the most recent adjustment to the HAMP program advocates principal forbearance to a 115% LTV as a (voluntary) first step in reducing borrowers' payments. Further payment reductions to reach the targeted debt/income ratio (DTI) of 31% are achieved through rate cuts, term extension and further principal forbearance.

In my view, these revisions to HAMP will not improve what has increasingly come to be viewed as an ineffective program even by some members of the Obama administration. (SIGTARP, in its quarterly report to Congress, said that "HAMP risks being remembered...for bold announcements, modest goals, and meager results.") In addition to being overly complex, placing the responsibility for implementation on servicers is incompatible with the economics of the industry. Servicers are built to be highly automated entities that rely on efficient processing of large numbers of transactions. Adding principal reduction to the already daunting series of decisions required to service nonperforming loans will further slow the evaluation process, helping few homeowners while extending foreclosure timelines and the overhang of distressed properties in local real estate markets.

If the goal is to provide short-term assistance to troubled borrowers, a simpler approach should be adopted. Temporary payment relief could be granted simply by allowing troubled borrowers to make interest-only payments on their loans for a predetermined period of time. Borrowers should be granted the principal exemption by documenting their hardship, possibly by simply demonstrating that their DTI is greater than a certain threshold. To mitigate future payment shock, the loan terms can be extended based on the amount of time the interest-only option is used. For example, a loan with a remaining term of 300 months could have all principal deferred for two years; its remaining term would be extended to 324 months. In most cases, deferring principal payments will have a similar impact on DTIs as HAMP, without the associated complexity and delays. (Clearly, option ARMs would need to be addressed separately.)

Unfortunately, the widespread problem of negative equity and its impact on borrowers' willingness to pay is not amenable to sweeping solutions. It is inconceivable that Congress will create a program to bring underwater borrowers back to the break-even point. In addition to being prohibitively expensive (Corelogic estimated that the dollar value of negative equity was around $800 billion), there is no political appetite to bail out homeowners on what are widely viewed as poorly-timed home purchases or equity removal.

While broad solutions to the problems of negative equity and strategic defaults are not feasible, more limited and targeted initiatives should be considered. For example, subsidies and tax credits can mitigate the short-term problem of underwater homeowners unable to accept job offers requiring relocation due to their inability to realize losses on the sale of their homes. Such changes should be included as part of programs supporting employment and job creation.

A broader problem is that numerous homeowners have seen declines in their homes' values so severe that they have little hope of ever recouping their investment; walking away is their only hope of freeing themselves from overwhelming long-term burdens that impairs their ability to make routine living arrangements. These homeowners could be aided by the creation of public and/or private home rental exchanges, along with loan programs (most likely through the Federal Housing Administration) that would allow them to receive mortgages for new home purchases. Such a loan would be contingent on their current homes being rented and the debt continuing to be serviced. The key is to create incentives for borrowers to stay in their homes and maintain their properties without being permanently prevented from engaging in normal life decisions.

Permanent reduction of principal should be accomplished only through the bankruptcy process. The industry should drop its opposition to "bankruptcy cramdowns" (i.e., a reduction in principal ordered by a bankruptcy judge). BlackRock has released a proposal to this effect calling for changes to the bankruptcy code designed specifically to deal with troubled homeowners. In my opinion, the problems and risks associated with cramdowns cannot be worse than the chaotic, ad-hoc approach currently being pursued.


Bill Berliner is a mortgage and capital markets consultant based in Southern California. His Web site is www.berlinerconsulting.net.

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