“Principal Reduction Modification (PRA)”

Lenders will receive far more value from Principal Reduction Modifications than from other mortgage modifications.

Obviously, this statement does not sound right. How could a bank make more money by reducing a $250,000 mortgage to $200,000? Here’s how:

If enforcing a $250,000 mortgage is likely to result in a foreclosure, the Lender will probably recover less than $100,000. If reducing the principal balance to $200,000 is likely to avoid foreclosure, the Lender will likely recover the entire new $200,000 balance, which is more than double what it might recover if it refuses to reduce the principle balance. Banks lose 40% of the value by the time they close-out the foreclosure. Example, for 200,000 houses they will net 120,00 by the time the bank closes the file and gets paid (Source: President of Chase Mortgage).

In order to calculate the Lender’s financial advantage or disadvantage of granting Principal Reduction Modifications, numerical probabilities must be established for the likelihood of outcomes mentioned above.

This report will compare the Net Present Value (NPV), of standard Home Affordable Modification Program (HAMP), modifications with Principal Reduction Alternative HAMP (PRA HAMP) modifications. If the mortgage principal balance on a home exceeds 115% of its market value, PRA HAMP will reduce the principal balance by that difference over a three year period, if the borrower stays current on the mortgage during that time. PRA HAMP will also reduce the interest rate, extend term, and include principal forbearance, if necessary, to reduce the monthly payment to 31% of gross income. Standard HAMP modification will do all but reduce principal balance.

Participating HAMP Lenders and Servicers, herein collectively referred to as Lenders, are required to start evaluating cases for PRA HAMP. Regardless of the outcome of those evaluations, no PRA HAMP modification would ever be required of the Lender. THEY WONT TELL YOU!!! PRA HAMP modification is strictly optional. A Lender could reject the application for any reason or for no reason at all.

It’s encouraging that some Lenders have issued PRA HAMP modifications with large principal reductions. That suggests those few Lenders understand the economic advantage of PRA HAMP, but it’s too early to tell how many will embrace the concept and actively participate.

Here is an example of one that we have done:

Amount owed……………………. $515,000

Payments behind………………. 29 at $4,300 per month

Interest Rate…………………….. @ 9.75% Adjustable Rate

PRA Amount…………………….. $363,000

New Payment…………………….$2,335.14

New Interest Rate……………… @ 3.75 Fixed

Principal Reduction…………… $152,000

Do you think this person wants to stay current now?

“Restoring the borrower’s incentive to pay in this way (referring to principal reduction) nearly quadruples the reduction in re-default rates achieved by payments reductions through interest rate modifications and term extensions alone.”

Re-default Rate: As it relates to mortgage modifications, this is the rate at which homeowners default after receiving a modification. Unless otherwise noted, re-default rate refers to the rate during the 12 months immediately following the modification. The impact of a re-default will have the same financial result for HAMP and PRA HAMP modifications.

Re-default rate is the single most important factor when comparing the NPV of a PRA HAMP with that of a standard HAMP modification. A lower re-default rate for Principal Reduction Modification provides the Lender savings to offset the reduction in principal balance.

The key question when comparing PRA HAMP to standard HAMP modification is whether the savings from a reduction in re-default rate will be more or less than the amount of the principal reduction. For the answer to that question, one can look to The Federal Reserve Bank of New York Staff Report: 

Second Chances: Subprime Mortgage Modification and Re-Default

This report, referred to herein as the FRB Report, was the result of no small effort. It is a 46-page, well researched and crafted report utilizing a sample of tens of thousands of mortgage modifications on which to draw conclusions. Principal Reduction Modifications were included in a sufficient number for the authors to state the following conclusion in the Abstract: “…the re-default rate declines relatively more when the payment reduction is achieved through principal forgiveness as opposed to lower interest rates.”

On page 30, the report states “restoring the borrower’s incentive to pay in this way (referring to principal reduction) nearly quadruples the reduction in re-default rates achieved by payment reductions through interest rate modification and term extensions alone.”

It goes on to state the conclusions “confirm the findings from previous research that the borrower equity is a critical determinant of loan performance…” The report concludes modifications will be more effective if program designs are more attentive to borrower incentives to pay, i.e., principal reduction.

HAMP vs. PRA HAMP: While the FRB Report does not specifically compare PRA HAMP with HAMP, it does provide an applicable  estimate of the difference in re-default rates for principal reduction and non-principal reduction modifications.

Attached are NPV Test results with parameters of the above referenced typical case, comparing a HAMP to a PRA HAMP modification, utilizing the re-default rate differential used in the FRB Report. Followed are the inputs used for the test:

Mortgage Balance: $250,000

Market Value: $175,000

Gross Income: $4,000

Current House Payment: $1,966

Re-Default Rates:

Principal Reduction: $48,750

In-House: 85.0%

HAMP: 40.0% (Less than 5% of homeowners qualify)

PRA HAMP: 10.7%

In-House Modification: A modification that is done with in the banks firm. Generally, this type of modification is done within 2-3 weeks. Most of the time these modifications are done when all other modifications have failed, however be aware.. with this modification most of the time the lender will want more money up front from the homeowners.

What is better for Mr. Banker?

NPV (Net Present Value) Comparison of HAMP vs. PRA HAMP Modifications

NPV (Net Present Value) of 10 Standard HAMP Modifications:

In these examples the Lender Recovery Rate LRR is $69,043.

Lender Recovery Rate: What it costs to take the average U.S. home back through the foreclosure process… without bankruptcy or stalling tactics. Approx. 40%

6 successful modifications…………………………………………. 6 x $224,112 = $1,344,674

4 re-defaults with foreclosure……………………………………….. 4 x $69,043 = $276,172

Total NPV (Net Present Value) for 10 modifications………………………………… $1,620,846

NPV (Net Present Value) of 10 PRA HAMP modifications:

9 successful modification……………………………………………. 9 x $188,955 = $1,700,598

1 re-default with foreclosure……………………………………………. 1 x $69,043 = $69,043

Total NPV (Net Present Value) for 10 modifications……………………………….. $1,769,641

NPV Advantage of 10 PRA HAMPS over 10 HAMPs…………………………………… $148,794

NPV Average PRA HAMP Advantage per individual modification……………… $14,879

The NPV (Net Present Value) of a single, successful standard HAMP modification ($224,112 in the above case) will always be greater than the NPV of a single, successful PRA HAMP modification ($188,955 in the above case), due to the PRA HAMP principal reduction. However, the FRB Report suggests 4 of every 10 standard HAMP modifications will fail, while only about 1 in 10 PRA HAMP modifications will fail. Due to the low Lender Recovery Rates in foreclosure ($69,043 in the above cases), the average NPV for PRA HAMP modifications will exceed that of standard HAMP modifications.

There are also significant Lender tax benefits of PRA HAMP. In this case, the tax savings could amount to almost $20,000 in the first three yeas following the modification. Without tax benefits, the PRA HAMP NPV advantage over standard HAMP is more than $14,000 per typical modification. With tax savings, that Lender NPV (Net Present Value) advantage could double to over $30,000. Tax benefits may vary wildly among Lenders, and may provide no benefit at all for those with no profit to shelter. With or without tax savings, the financial gains from PRE HAMP modifications are considerable.

Even if PRE HAMP re-default rates were twice that indicated in the FRB Report, or if the Lender received no tax savings, or if both of those unlikely events transpired, the NPV for PRA HAMP modifications would still exceed the NPV for standard HAMP.

Reserve Requirements: A PRA HAMP will give rise to an increase in Lender cash reserve requirements. One could argue reserve requirements should be lowered by PRA HAMP, since those modifications are four times less likely to suffer re-default. Reserve requirements may be of little or no concern to large Lenders, but it should be recognized as a by-product of PRA HAMP.

Principal Reduction modifications are far too important to the economic resurgence of this country to allow “accounting and administrative” issues to block the way.

All in All: The Report demonstrates Principal Reduction Modifications will significantly reduce re-defaults, thereby creating substantially more value to Lenders than other modifications. When considering the Lender’s potential tax benefits, the already significant benefit of PRA HAMP is further increased. In the unlikely event the Lender receives no tax savings and the re-default rate for PRA HAMP is double that projected in the FRB Report, the NPV for PRA HAMP Modifications will still be greater then the NPV for standard HAMP modifications.

Under HAMP, a participating Lender is required to modify when doing so generates the most value for itself. Consistent with the HAMP concept, a PRA HAMP modification should be mandatory for participating Lenders when ever its NPV exceeds that of both standard HAMP modification and the “No Modification” alternatives.

For purposes of NPV calculation, the estimate PRA HAMP re-default rate should be 30% less than the standard HAMP re-default rate and 75% less than an In-House Modification. Over time, historical re-default rates should replace this proposed initial rate.

Under PRA HAMP, Lenders will achieve far greater financial benefits than with any current modification program, and borrowers will have a fighting chance to regain equity and security in their home. Even if prices remain flat and borrowers make no improvements to their homes, HAMP Principal Reductions combined with scheduled payments will reduce mortgage balance to within 5% of home values in just three years. That fact will reinvigorate homeowners and provide inspiration to stay current on mortgage payments for the many who today have no incentive or rational hope to save the home once cherished.

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