Principal Writedowns Make for Better Loan Modifications--But Nobody Does it

The Obama administration doesn't mandate principal reductions during loan modifications.

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President Barack Obama's loan modification plan gives servicers all kinds of options for getting a borrower's debt-to-income ratio down to that 31 percent threshold. They can extend the terms of the loan, lower the interest rate, and even--if they are so inclined--trim the unpaid principal balance of the loan itself. But the administration has been criticized for not mandating that servicers write down the principal balance when they modify a loan, which, some argue, would improve the effectiveness of the program.

"For underwater loans, if you don't write down the balance to be less than the value of the house, people still have an incentive to default," Richard Green, the director of the Lusk Center for Real Estate at USC, told me when the details of the plan were unveiled in early March. "Writing down the principal first instead of last—which is what [the Obama administration is] proposing—makes sense to me."

[See Obama's Loan Modification Plan: 7 Things You Need to Know]

Judging from Lender Processing Services' June Mortgage Monitor Report, which was released Thursday, it seems that Green was correct. The report found that "the success rate for loss mitigation-related loan modification hovers in the 30-40% range, with a higher success rate for loan modifications involving a reduction in unpaid principal balance."

Here's a good visual of the trend (UPB stands for unpaid principal balance) from LPS:

Still, while the percentage of principal writedown modifications has increased, servicers remain largely unwilling to reduce the outstanding balance of mortgages during modifications. As this chart shows, rate and term adjustments have become by far the most popular approach.

from LPS: