Credit Suisse Says Mortgage Principal Cuts Don’t Help Homeowners

Credit Suisse Says Mortgage Principal Cuts Don’t Help
Homeowners seeking to modify their mortgages speak with loan servicers at the Neighborhood Assistance Corp. of America's (NACA) "Save-the-Dream Tour" at the Colorado Convention Center. Photographer: Matthew Staver/Bloomberg

Reducing mortgage balances is a risky idea that hasn’t been shown to keep borrowers who owe more than their property’s worth in their homes, according to Credit Suisse Group AG.

Of the 11 million of “underwater” homeowners, about 6.5 million have never missed a payment and 2 million more are making on-time payments after a delinquency, said Dale Westhoff, the bank’s global head of structured products research. Widespread principal reductions may drive defaults “much, much higher” as borrowers seek the aid, he said.

“We’ve never done this before; we don’t know what the risk is,” Westhoff, a top-ranked mortgage-bond analyst in polls by Institutional Investor magazine for 15 years in a row while at Bear Stearns Cos., said today at a briefing for reporters in New York. Along with creating so-called moral hazard, the step may also tighten lending by forcing banks to offer “price protection” to borrowers, he said.

Credit Suisse’s view puts it at odds with Federal Reserve Bank of New York President William C. Dudley; Amherst Securities Group LP analyst Laurie Goodman, a member of the Fixed Income Analysts Society’s Hall of Fame; and hedge-fund manager Greg Lippmann, who last year advocated principal reductions, citing data from his former employer, Deutsche Bank AG.

Debt Forgiveness

Dudley said this month policy makers should consider allowing non-delinquent borrowers to earn debt forgiveness with on-time payments, while state attorneys general and federal regulators may encourage principal reductions as part of a settlement being negotiated with the biggest banks over their foreclosure practices.

Data Credit Suisse examined show essentially no difference in re-default rates among delinquent borrowers given only payment reductions and those also offered smaller mortgages, Chandrajit Bhattacharya, an analyst at the bank, said at the briefing.

Based on loans in mortgage bonds without government backing, about 40 percent of borrowers whose payments were cut between 20 percent and 40 percent defaulted again after 12 months, regardless of whether they were more than 60 percent underwater or had home equity between zero and 20 percent, according to Credit Suisse.

Data from bank regulators also show almost no difference in re-defaults among loans in the portfolios of banks, whose modifications include principal cuts 18 percent of the time, and mortgages guaranteed by government-supported Fannie Mae and Freddie Mac, which don’t lower balances, Bhattacharya said.

Resisting Calls

“You’ve got to base policy on something that’s factual,” he said. “You can’t base policy on something that you expect that hasn’t happened yet.”

Fannie Mae and Freddie Mac, the mortgage firms overseen by Federal Housing Finance Agency Acting Director Edward DeMarco, and lenders including Bank of America Corp. have resisted calls for widespread reductions of mortgage balances, saying the move is unnecessary or may encourage more homeowners to default.

The New York Fed’s Dudley said Jan. 6 that “analysis by my staff that looks at likely borrower behavior over an extended time horizon suggests that without a significant turnaround in home prices and employment, a substantial proportion of those loans that are deeply underwater will ultimately default -- absent an earned principal reduction program.”

Amherst’s Goodman says that principal reductions are needed to avoid 8 million to 10 million more distressed-property sales.

Principal Reductions

“We have shown that, even controlling for all other factors, principal reductions are more effective,” she said today in an e-mail. “Realize also that banks are doing it on their own portfolios and have been for years. Why would they continue if it was not more effective?”

Among subprime borrowers who received payment reductions of more than 40 percent in 2010, 19 percent defaulted after 12 months if their reworked loans included a lower balance, while 27 percent fell behind again if they only received a lower rate, according to a December report by Goodman’s team.

Lippmann, the former Deutsche Bank trader who gained fame for his bets against subprime mortgages before the housing market collapsed, is urging debt forgiveness for U.S. homeowners.

“Principal reductions are necessary to help ameliorate the housing crisis,” Lippmann, chief investment officer for New York-based hedge fund LibreMax Capital LLC, said in an Oct. 31 letter to investors obtained by Bloomberg News. The step will also lower losses on loans underlying mortgage bonds, he said.

Borrowers are 1.7 times more likely to default again after a loan is reworked without cutting the balance, he said, citing a Deutsche Bank report the previous month.

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