Principal reductions

Felix Salmon asks why banks are reluctant to modify loans rather than foreclose and concludes:

Why are the banks behaving like this? I think the obvious answer is the right one: they’re holding these loans on their books at much more than they’re really worth, and they can’t afford to take the write-downs which would accompany principal reductions of roughly the same magnitude as the decline in housing prices. This kind of head-in-the-sand behavior can only possibly work if housing prices suddenly rebound in the next couple of years, and that ain’t gonna happen.

The obvious alternative explanation is principal reductions generally are not in the banks best interest. Most people with underwater mortgages will not in fact default. So writing everyone down to market value is a loser for banks, the amount they may gain by avoiding foreclosures is outweighed by the losses on the mortgages that would have been paid in full.

And I think the harm caused by foreclosures is being exaggerated. Foreclosures are associated with falling market values but this does not mean they cause falling market values. Instead falling market values cause foreclosures.

There has been a lot of talk about keeping people in their homes but in many cases everyone is better off with a quick and clean default.