11 July 2011

Principal Reductions In Mortgage Modifications Follow Pattern

Banks will sometimes modify mortgages to reduce principal if they are already shown at a discount on their books due to an acquisition from another bank, especially if the mortgages are currently not in default, but not if the write down will produce an accounting loss for the bank.

It seems that Wells and JP Morgan are happy to do principal reductions only on the mortgages they bought at a discount from Wells Fargo and WaMu respectively; Bank of America, meanwhile, which inherited a bunch of these loans when it acquired Countrywide, is not doing principal reductions, and I don’t think it’s a coincidence that the Countrywide loans were bought at very close to par.

The behavioral psychology here is very easy to understand. No bank wants to admit that it wrote idiotic loans, and write down its own assets from par. Meanwhile, it’s much easier to write up an acquired asset, if the amount you reduce the loan is less than the discount you bought the loan for in the first place.

Economically speaking, however, what the banks are doing here does not make sense. Either writing down option-ARM loans makes sense, from a P&L perspective, or it doesn’t. If it does, then the banks should do so on all their toxic loans, not just the ones they bought at a discount. And if it doesn’t, then they shouldn’t be doing so at all.

The truth is, of course, that banks should be doing principal reductions, and they should be doing them on lots of their loans, rather than just the ones they bought cheap. And the fact that they’re already doing this, entirely voluntarily, on some of their loans is the best possible indication that it makes perfect economic sense to do so on all of their loans. Even if doing so might involve admitting that the subprime crisis still isn’t fully over.

The implication is that the financial accounting reform may be a key to responding more rationally to the current and future asset bubbles.

The results also shed doubt on the prevailing assumption that banks act in an economically rational way, which makes reforms, like cramdowns in bankruptcy, that force lenders to act rationally rather than based on the reputational effect of a decision for actors in the organization look attractive.

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