While principal reductions help lower a modified loan's monthly payment, initial limited data for modifications with large balance reductions (20% or more) exhibited higher redefault rates than loans with principal and interest (P&I) payment reductions of 20% or more, according to Fitch Ratings.
Fitch believes that servicers must determine the borrower's actual level of income, and craft a modification suitable to that income level, if possible. ‘Some combination of payment reduction and either principal forbearance or forgiveness may be the most effective approach to mortgage modification, as it may increase borrower ability and willingness to repay the modified amounts,’ says Diane Pendley, managing director and head of Fitch's Operation Risk Group. ‘However, when principal forgiveness is used – as opposed to forbearance where a portion of principal is ballooned to the end of the term – it should be carefully considered and tied to the current value of the home.’
Fitch's analysis of 60-days-plus delinquency data obtained from First American Loan Performance shows that the amount of the principal reduction has not made a great deal of difference to date in the success of the modification. For loans that had a principal reduction of 20% or more, roughly 28% had redefaulted six months later. Loans with a principal reduction by up to 10% had a similar redefault rate of about 30%. This compares to a 30% redefault rate for loans that had their principal balance increased by up to 10%. Modifications may increase a loan's principal balance due to capitalization of past due interest and other costs.
P&I payment decreases appear to have had a more direct impact on the percentage of loans that later redefault. The data for these loans show a greater range of redefault percentages. Loans modified to include a 20% or greater reduction in P&I experienced a 21% redefault rate within six months. That compares to a 49% redefault rate for loans with 10% to 20% increases in P&I. The data indicates that decreases in P&I at modification cause distinct decreases in redefault rates six months later.
This suggests that a strategy that focuses on borrowers' cash flow and reduces their payment-to-income ratio to an affordable level has been more effective, to date, at helping borrowers stay current with the modified payment than a principal reduction, according to Group Managing Director and U.S. RMBS group head Huxley Somerville.
‘Servicers are likely to use a combination of interest-rate reductions, extended amortization, forgiveness of delinquent amounts, and/or principal forbearance or forgiveness as part of their loan workout strategy,’ says Pendley. ‘In addition, several servicers have announced reducing targeted post-modification payment-to-income percentages in order to lower re-default rates, as these calculations typically omit other debt, such as second liens and consumer loans.’
SOURCE: Fitch Ratings