In a press conference held last week, Credit Suisse analysts said that the rampant use of principal forgiveness is a dangerous path because it promotes moral hazard.

The true key to avoid moral hazard as well as what drives the re-default rate is not the type of modification but the level of payment reduction to the borrower’s mortgage.

“It’s not about the lack of equity but about reducing the monthly payment,” said Dale Westhoff, global head of securitized product research at Credit Suisse. “Forgiving the principal on delinquent borrowers penalizes the majority of borrowers that have never missed a payment, providing them an incentive to default.”

Westhoff presented data that showed that roughly 25% of the borrower universe (comprising 49 million borrowers), which is equivalent to 12 million, has little or in negative equity. Of this number, 11 million or 22% have truly negative equity while around 1 million are on the cusp.

The government’s principal reduction efforts are targeted toward 2.2 million of homeowners, which is also the portion of the population that is delinquent. However, 8.5 million of the underwater borrower universe is current on their mortgages and 6.5 million of whom have never missed a payment.

Additionally, 2.2 million are borrowers that have never missed payment and are deeply negative equity (>125 LTV). These homeowners would be the first to strategically default under broad principal reduction program.

The whole point is that data suggests that redefault is driven by the level of monthly payment reduction not type of mod. Why take on massive moral hazard risk when we don't have to?In the presentation, Westhoff showed that for every delinquent underwater borrower, there are four who are making payments, further demonstrating that the lack of correlation between delinquency and negative equity.

Chandrajit Bhattacharya, director and head of non-agency RMBS and ABS strategy at Credit Suisse, stated that there is no relationship between borrower LTV and the re-default rate.

"The data does not show any relationship between borrower LTV and the re-default rate." he said.
“LTV is a precondition for a default and not a causal relationship.”

In a chart Bhattacharya presented, he showed a comparison between bank portfolios and those for the GSEs. Banks are required to do principal reductions on many of their borrowers, while the GSEs do not perform these types of modifications on their loans. However, the re-default experience between these portfolios are similar, Bhattacharya said.

“You can do sustainable and proper payment relief without incurring moral hazard,” he stated.

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.