[26-Apr-2013] Principal Forgiveness, Still The Best Way To Limit U.S....

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RatingsDirect Research

Principal Forgiveness, Still The Best Way To Limit U.S. Mortgage Redefaults, Is Becoming More Prevalent
26-Apr-2013

In June of last year, Standard & Poor's Ratings Services contended that principal forgiveness was more likely to keep U.S. mortgage borrowers current than more commonly used modification tools (see "The Best Way to Limit U.S. Mortgage Redefaults May Be Principal Forgiveness," June 15, 2012). Data gathered since then not only support this view but also demonstrate servicers' growing adoption of this form of loss mitigation. As of February of this year, more than 1.5 million homeowners have received a permanent modification through the U.S. federal government's Home Affordable Modification Program (HAMP). Since the publication of our June 2012 article, there have been more than 400,000 additional modifications on outstanding mortgages (as of March 2013). This translates to roughly a 22% rate of growth in the number of modifications on an additional $2.4 billion in mortgage debt. Under the HAMP Principal Reduction Alternative (PRA) program, which provides monetary incentives to servicers that reduce principal, borrowers have received approximately $9.6 billion in principal forgiveness as of March 2013. Interestingly, servicers have ramped up their use of principal forgiveness on loans that don't necessarily qualify for PRA assistance. Indeed, among the top five servicers for non-agency loans, we've noted that principal forgiveness, as a percentage of average modifications performed on a monthly basis, has increased by about 200% since the latter half of 2011 (see Chart 1). We attribute part of this to the $25 billion settlement in February 2012 with 49 state attorneys general and these same five servicers: Ally/GMAC, Bank of America, Citi, JPMorgan Chase, and Wells Fargo). In fact, although principal reduction remains the least common type of loan modification among servicers, the percentage of non-agency modified loans that have received principal forgiveness has increased by 3% since June 2012 (see Chart 2). Since 2009, servicers have forgiven principal on approximately $45 billion of outstanding non-agency mortgages.*
Chart 1

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Chart 2

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Home Equity Is Still Key To Borrower Retention

In our initial research, we compared the average mark-to-market (MTM) loan-to-value (LTV) of modified loans at the time of modification with the value at the end of the first quarter of last year (see Table 1). When we revisited the same population of loans as of March of this year, we noted that LTVs have slightly lowered overall, in part because of an improvement in house prices. However, principal-reduced loans remained the only sub-sector with LTVs staying well below 100%.
Table 1 Change In Average MTM LTV On Modified Loans Modification type Rate modification Balance capitalization Other debt reduction Principal reduction LTV at origination 80 78 79 78 MTM LTV at time of modification 99 91 106 106 MTM LTV as of April 2012 107 110 113 82 MTM LTV as of March 2013 101 105 104 79 % change between origination and March 2013 26.25 34.62 31.65 1.28

Sources: Core Logic and FHFA March 2013 Index.

Permanence And Redefaults

While our analysis shows average 12-month loss severities for principal-reduced loans to be about 80% compared with 72% for other types of modified loans, our original research had demonstrated that principal reductions displayed a lower rate of re-default than other modification methods. The latest data show that this trend has continued. As of March 2013, loans that received a principal reduction maintained the highest percentage (about 76%) of current-pay borrowers. By contrast, on average less than 50% of loans outstanding that received a modification other than principal forgiveness remained current.
Table 2 Delinquency Profile Of Modified Loans (%) Current 30-day 60-day 90+-day F/C REO Rate reduction 58.57 10.15 4.73 12.85 11.96 1.73 Balance capitalization 54.32 8.42 4.43 15.83 15.03 1.97 Other debt reduction 27.66 4.76 2.51 27.85 31.37 5.85 Principal reduction 76.65 7.81 2.88 7.87 4.25 0.54

Source: Core Logic March 2013 performance.

The rate of repeat modifications on the same loan continues to favor principal forgiveness as a more permanent mitigation tool. Although the percentage of loans with interest rate reductions that have received them more than once increased to 30% from 25% as of June of last year, loans with multiple principal reductions have remained steady at only 5% (see Chart 3).
Chart 3

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Improvements In Housing And Servicing As Support

As we acknowledged last June, price depreciation potentially posed the largest drawback to greater utilization of principal forgiveness. Further depreciation in a home's value could erode a borrower's incentive to stay in the home even after a debt reduction. This could lead to a re-default and liquidation at a potentially higher overall loss severity when adding the initial loss that the lender absorbed at the time of the modification. Although our research still demonstrates the likelihood that servicers will recover a greater portion of their receivables through principal forgiveness versus other modification tools, we believe the impact of stable house prices is significant.

Notes
*Due to different reporting mechanisms and information available among the multiple participants that service loans backing the multiple RMBS, we applied a custom methodology in our analysis to determine whether a non-agency loan had been modified and in what form. When we didn't classify a particular loan as being modified, yet supplemental reporting indicated that some form of debt reduction had occurred that resulted in a collateral loss, we then categorized the modification as "other debt reduction." We used the March 2013 Federal Housing Finance Agency home price index to adjust the LTVs. In certain cases, the initial principal amount forgiven may be included in the total loss amount calculated for the loan at liquidation. Primary Credit Analyst: U.S. RMBS: Cesar Romero, New York (1) 212-438-4666; cesar_romero@standardandpoors.com Vandana Sharma, Analytical Manager, New York (1) 212-438-2250; vandana_sharma@standardandpoors.com

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