Proposed Settlement To Force Lenders To Pay For Principal Loan Reductions

February 24, 2011

Will The Government Force Loan Servicers To Settle?

The Wall Street Journal is reporting that The Obama administration is trying to push through a settlement with the major loan servicers that could force America’s largest banks to be on the hook for reductions in loan principal worth billions of dollars.  News of the proposed settlement is noteworthy because it would be the first program that would require the banks to reduce the loan balances of troubled borrowers who owe more than their homes are worth.  So far, all other loan modification programs have focused on shrinking monthly payments by lowering interest rates and extending loan terms.  These programs have been widely regarded as a failure and skeptics continue to warn that rising numbers of underwater borrowers will drag on housing markets and the economy for years unless more is done to help them.

Until now, banks have been reluctant to embrace principal reductions, mostly due to concerns that many borrowers who can afford their loans will simply stop paying in the hope of being rewarded with a smaller loan.  In the few cases where the servicer has agreed to a reduction in principal, these writedowns were passed along to investors who purchased mortgage-backed securities or the US taxpayer.  Under the administration’s proposed settlement, banks would have to bear the cost of all writedowns rather than passing them on to other investors. The settlement proposal focuses on pushing servicers who mishandled foreclosure procedures to eat losses, by writing down loans that they service on behalf of clients. Those clients include mortgage-finance giants Fannie Mae and Freddie Mac, as well as investors in loans that were securitized by Wall Street firms.

It is important to note that while no settlement is imminent, rumors may at least indicate that the Obama administration is finally getting serious about taking steps to force lenders to pay for the breakdown in foreclosure practices that erupted last fall.  Even if a settlement is ultimately reached, it is still uncertain as to how many homeowners would actually benefit from a deal.  Lenders and servicers are clearly having difficulty managing the volume of troubled loans and a majority of underwater homeowners may prefer to simply walk away from their property or pursue a short sale.  An underwater homeowner may simply choose to remain in the property rent free while they simply wait out the foreclosure process that can easily take more than a year. Until now, lenders have had no incentive to address these issues.  News of a proposed settlement, however, may finally force the banks to be accountable for their unscrupulous lending and loan servicing practices.

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