(The following statement was released by the rating agency)
March 01 - The benefits that principal reductions may offer need to be weighed against the potential for an increase in moral hazard risk which may, over time, precipitate higher mortgage defaults, according to Fitch Ratings.
The State Attorneys General recently announced settlement with major mortgage servicers include an agreement to offer principal reductions to help struggling borrowers keep their home. On the surface, this seems to be a sensible approach as loan modifications with principal reductions have performed better than other types of modifications. However, if not implemented carefully, a wide-ranging principal reduction program could actually increase voluntary defaults.
A large number of deeply underwater prime borrowers are currently performing as are over 50% of the Alt-and subprime borrowers. While equity remains a key performance driver in these sectors, other risk factors are contributing to defaults that cannot be addressed by principal forgiveness. This is most evidenced by the number of borrowers with positive equity that are having trouble keeping up with the mortgage payment.
While principal reduction mods perform better than those with a rate or payment cut, redefaults among those with deep balance cuts still remain north of 20%. Most mortgage re-defaults arise from borrowers being sizably weighed down with non-mortgage debt after their loan has already been modified. To make the mod payment sustainable, servicers may begin using back-end debt ratios to determine the principal balance cut. Such an action may effectively force the first lien investor to subsidize the repayment of the borrower's consumer debt, thus increasing the potential incidence of defaults among over-leveraged or marginally underwater borrowers looking to qualify for such a reduction.
If applied judiciously, Fitch believes that a targeted plan that determines borrower eligibility for principal reduction would be effective if the mortgage payment decrease is limited to a reasonable payment-to-income ratio. This approach would be more effective in keeping at-risk borrowers in the homes without significantly increasing moral hazard risk.
Fitch will continue to monitor developments to determine the potential impact on RMBS ratings. 'Principal Reductions Cut Both Ways for U.S. RMBS' is available at 'www.fitchratings.com' or by clicking on the below link.
Link to Fitch Ratings' Report: Principal Reductions Cut Both Ways for U.S. RMBS