Why Banks are Reluctant to Reduce the Mortgage Principal?
Banks have been very reluctant to offer mortgage modifications that reduce the principal balance of mortgages. We use an example to explain the banks’ reasoning. We assume banks maximize the expected value cash flows they receive.
Suppose a home was last sold for $400,000 with a $300,000 mortgage. It is now worth $200,000 and it would cost the owner of the mortgage an additional $75,000 to foreclose. If the mortgage balance were reduced to $150,000, there is no chance of default. In that case, the current owner would sell the house rather than default if he could not continue to make the mortgage payments.
Since the home was last sold for $400,000 and is now worth only $200,000, there is $200,000 loss that cannot be avoided. It will be divided between the bank and the homeowner. In addition, there may be another $75,000 of expenses that will be incurred if the final solution involves a default.
The bank’s alternatives are to maintain the loan balance or offer a loan modification. If it modifies the loan bank will receive $150,000. If the bank does not modify the loan, and the homeowner defaults, the bank receives a $200,000 house and incurs $75,000 of expenses to dispose to the house, so its net proceeds are $125,000. If the bank does not modify the loan and the homeowner does not default, the bank receives $300,000.
If the bank believed that the homeowner would certainly to default in case the loan was not modified, it would modify the loan. But if the bank believed that there was even a small probability (14.7% or more) the homeowner would pay the $300,000 mortgage, then will minimize its expected loss by not modifying the loan.
This example illustrates that a major obstacle to loan modification in the current situation is that homeowners are too willing to repay mortgages even when their home is under water. This discourages banks from modifying loans. If homeowners were as opportunistic as banks and were willing to walk away from loans whenever it was in their best interest to do so, without regard to moral qualms, then more loans would be modified and there might be fewer defaults overall.