Despite a general reluctance by servicers historically to engage in loan modifications that include reducing principal balances, recent loss mitigation initiatives announced by the Federal Reserve and Wells Fargo indicate the tide is turning in favor of such reductions. One major servicer of subprime loans, Litton Loan Servicing LP, reports that it has increased its use of principal write-downs in order to achieve a 31% mortgage debt-to-income (DTI) ratio for modified loans.
Litton, which shifted its loan modification policy last November to target the 31% DTI ratio rather than the previous industry standard of 38%, says principal reductions are now included in about one third of its total modification actions. In November, modifications with principal reductions totaled almost 19% of all mods, the company told Servicing Management.
According to a study published recently by Alan M. White, an assistant professor at the Valparaiso University School of Law, Litton was one of two servicers studied that reduced principal with any regularity – the other being Ocwen.
While academic and federal research indicates many loan modifications increase monthly mortgage payments by recasting arrears, modifications completed by Litton last December resulted in an average monthly payment drop of 26.6%. To achieve the 31% DTI ratio, Litton first reduces a loan's interest rate. If further modification is needed, Litton then examines extending a loan's terms to 30 years, waiving fees or accrued interest, and/or reducing principal.
Prior to November's DTI policy change, analysis performed by the company showed that modifications that included principal reductions were 50% less likely to redefault, according to a company representative. A report issued jointly by the Office of the Comptroller of the Currency and the Office of Thrift Supervision in December suggested that the majority of loans modified in the first half of 2008 redefaulted, causing many lawmakers to argue that loan modifications are an insufficient solution to preventing foreclosures.